UNITED
STATES
 SECURITIES
AND EXCHANGE COMMISSION
 Washington,
D.C.  20549
 _____________
 
 Form
10-K
 _____________
 (Mark
One)
 T
              ANNUAL REPORT PURSUANT TO
      SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934
 For the
fiscal year ended: December 31,
2008
 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 No.: 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.)
 
 Suite
1100, 10 Middle Street
 Bridgeport,
CT  06604
 _________________________________________
 (Address
of principal executive offices) (Zip Code)
 
 Registrant’s
telephone number, including area code:  (203)
416-5290
 
 Securities
registered pursuant to Section 12(b):
 
 Title
      of each class
                
                Name
      of each exchange on which registeredCommon
      Stock, $0.01 par value
                
                The
      NASDAQ Stock Market LLC
 
 Securities registered pursuant to
Section12(g): None
 
 Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
rule 405 of the Securities Act.  Yes £ No T
 
 Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act.  Yes £ No T
 
 Indicate
by check mark whether the registrant: (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.  Yes T No £
 
 Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of the registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. o
 
 Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act.
 Large
Accelerated filer £        
Accelerated filer T        
Non-accelerated filer £        
Smaller reporting company £
 (Do not check if a smaller reporting company)
 
 Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).  Yes £ No T
 
 The
aggregate market value of the voting stock held by non-affiliates of the
registrant based on the last sale price as of June 30, 2008 was
$94,164,815.
 
 As of
March 10, 2009, the outstanding number of shares of the registrant’s common
stock, par value $0.01 per share, was 8,138,304.
 
 Documents incorporated by
reference:
 
 Certain
portions of the proxy statement for the annual meeting of stockholders to be
held on May 13, 2009 are incorporated by reference into Part III of this
report.
  1
 CLEAN
DIESEL TECHNOLOGIES, INC.
 
 Annual
Report on Form 10-K
 For
the Fiscal Year Ended December 31, 2008
 
 
 Tableof
Contents
 
 PART
      I1.
                    
                    Business
                    
                    31A.
                    
                    Risk Factors
                    
                    141B.
                    
                    Unresolved Staff Comments
                    
                    192.
                    
                    Properties
                    
                    193.
                    
                    Legal Proceedings
                    
                    194.
                    
                    Submission of Matters to a Vote of Security
      Holders
                    
                    19PART
      II5.
                    
                    Market for Registrant’s Common Equity, Related Stockholder
      Matters and Issuer Purchases of Equity Securities
                    
                    196.
                    
                    Selected Financial Data
                    
                    227.
                    
                    Management’s Discussion and Analysis of Financial Condition and
      Results of Operations
                    
                    237A.
                    
                    Quantitative and Qualitative Disclosures about Market
      Risk
                    
                    338.
                    
                    Consolidated Financial Statements and Supplementary
      Data
                    
                    349.
                    
                    Changes in and Disagreements with Accountants on Accounting and
      Financial Disclosure
                    
                    589A.
                    
                    Controls and Procedures
                    
                    589B.
                    
                    Other Information
                    
                    59PART
      III10.
                    
                    Directors, Executive Officers and Corporate
      Governance
                    
                    6011.
                    
                    Executive Compensation
                    
                    6012.
                    
                    Security Ownership of Certain Beneficial Owners and Management
      and Related Stockholder Matters
                    
                    6013.
                    
                    Certain Relationships and Related Transactions, and Director
      Independence
                    
                    6014.
                    
                    Principal Accounting Fees and Services
                    
                    60PART
      IV15.
                    
                    Exhibits and Financial Statement Schedules
                    
                    61SIGNATURES
                    
                    
                    
                    65
 
 _____________________________
 
 
 The
information called for by Part III, Items 10, 11, 12, 13 and 14, to the extent
not included in this Annual Report on Form 10-K, is incorporated herein by
reference to the information to be included under the captions “Election of
Directors,” “Directors and Executive Officers of Clean Diesel Technologies,”
“Section 16(a) Beneficial Ownership Reporting Compliance,” “Committees of the
Board,” “Executive Compensation,” “Directors’ Compensation,” “Employment
Contracts and Termination of Employment and Change in Control Arrangements,”
“Compensation Committee Interlocks and Insider Participation,” “Report of the
Compensation Committee on Executive Compensation,” “Security Ownership of
Certain Owners,” “Security Ownership of Officers and Directors” and “Appointment
of Independent Registered Public Accounting Firm” in the definitive proxy
statement to be filed in connection with Clean Diesel Technologies, Inc.’s 2009
annual meeting of stockholders.
  2
 Table of Contents
  PART
I
 
 Item1.
              Business
 
 Pursuant
to the safe harbor provisions of the Private Securities Litigation Reform Act of
1995, this Annual Report on Form 10-K contains forward-looking statements
that reflect our estimates, expectations and projections about our future
results, performance, prospects and opportunities.  Forward-looking
statements include all statements that are not historical
facts.  These statements are often identified by words such as
“anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “plan,” “may,”
“should,” “will,” “would” and similar expressions.  These
forward-looking statements are based on information available to us and are
subject to numerous risks and uncertainties that could cause our actual results,
performance, prospects or opportunities to differ materially from those
expressed in, or implied by, the forward-looking statements we make in this
Annual Report.  The discussion in the section “Risk Factors” in
Item 1A. of this Annual Report highlight some of the more important risks
identified by management but should not be assumed to be the only factors that
could affect our future performance.  Additional risk factors may be
described from time to time in our future filings with the Securities and
Exchange Commission (SEC).  Accordingly, all forward-looking
statements should be evaluated with the understanding of their inherent
uncertainty.  You should not place undue reliance on any
forward-looking statements.  Risk factors are difficult to predict,
contain material uncertainties that may affect actual results and may be beyond
our control.  Except as otherwise required by federal securities laws,
we undertake no obligation to publicly update or revise any forward-looking
statements, whether as a result of new information, future events, changed
circumstances or any other reason.
 
 Unless
otherwise indicated or required by the context, as used in this Annual Report on
Form 10-K, “CDT” and the terms “Company,” “we,” “our” and “us” refer to
Clean Diesel Technologies, Inc. and its wholly-owned subsidiary, Clean Diesel
International, LLC.
 
 The
Clean Diesel Technologies, Inc. name and logo, Platinum Plus®,
ARIS® and
Biodiesel PlusTM are either registered trademarks or trademarks of Clean Diesel
Technologies, Inc. in the United States and/or other countries.  All
other trademarks, service marks or trade names referred to in this Annual Report
are the property of their respective owners.
 
 General
 
 We
develop, design, market and license patented technologies and solutions that
reduce harmful emissions from internal combustion engines while improving fuel
economy and engine power.  We are a Delaware corporation formed in
1994 as a wholly-owned subsidiary of Fuel Tech, Inc., a Delaware corporation
(formerly known as Fuel-Tech N.V., a Netherlands Antilles limited liability
company) (“Fuel Tech”).  We were spun-off by Fuel Tech in a rights
offering in December 1995.  Since inception, we have developed a
substantial portfolio of patents and related proprietary rights and extensive
technological know-how.
 
 Key operating activities in 2008
include the following:
 
 ·
              Licensed
      wire mesh filter technology to Headway Machine Co., Ltd. (Zhucheng City,
      China), the largest commercial diesel engine exhaust company in China
      which enables Headway to develop the wire mesh filter technology to
      provide particulate matter emission reduction solutions to China-based
      truck manufacturers.
 ·
              Received
      approval for the inclusion of our Purifier e4 retrofit technology in the
      Scottish Government Emissions Reduction Register
  program.
 ·
              Executed
      a worldwide, non-exclusive license agreement with Hilite International,
      Inc., a leading supplier of automotive powertrain components headquartered
      in Cleveland, Ohio that covers our patented Advanced Reagent Injector
      System (ARIS) airless injection technology for selective catalytic
      reduction (SCR) control of vehicle oxides of nitrogen emissions and rights
      to our patented combination of the use of exhaust gas
      recirculation (EGR) in conjunction with SCR for reducing fuel
      consumption while meeting stringent emissions
  standards.
 ·
              Executed
      non-exclusive worldwide license agreement with Eaton Corp. (Ohio US) that
      covers our patented ARIS®
      technologies for control of oxides of nitrogen using SCR emission control
      and the combination of EGR with SCR technologies.  Eaton will
      use our technology for injection of hydrocarbon fuel in emissions
      reduction applications, including Eaton's Aftertreatment
      System.  This technology can also be applied to regeneration of
      diesel particulate filters and lean NOx traps in various global
      applications.
  3
 Table of Contents
  ·
              Supplied
      our Purifier particulate matter emission control technology as a retrofit
      solution to commercial operators owning older vehicles to comply with
      requirements for the London Low Emission Zone
  (LEZ).
 
 Ongoing
Operations Update
 
 The
Company’s key technologies and products are detailed below and they continue to
fuel the growth of the Company as key deadlines approach to meet more stringent
global emissions regulations.  Among them, the ARIS® technology
continues to be used by leading industry players, while the great majority of
engine manufacturers have publicly stated their intent to use the combination of
exhaust gas recirculation (EGR) and selective catalytic reduction (SCR)
technologies to meet more stringent emission regulations.  In
addition, global retrofit opportunities continue to expand as both countries and
locales worldwide attempt to address clean air issues.  As a result,
the Company is intensifying efforts to position its technologies as key,
market-proven enablers to reduce diesel emissions.  As a means to that
end, executive and structural changes have been made to aid in the Company’s
evolution from a research and development mindset to that of commercialization
and monetization of its intellectual property.  Moreover, critical
focus has been placed on firm operational controls further supporting the
Company’s transition to profitable growth.
 
 Technology
and Intellectual Property
 
 Our
technology is comprised of patents, patent applications, trade or service marks,
data and know-how.  Our technology was initially acquired by
assignment from Fuel Tech and has subsequently been primarily developed
internally.  As owner, we maintain the technology at our
expense.  The agreement with Fuel Tech provided for annual royalties
which commenced in 1998 and terminated in 2008 of 2.5% of the gross revenue
derived from the sale of the Platinum Plus®
fuel-borne catalyst, a diesel fuel additive for emissions control and fuel
economy improvement in diesel engines.
 
 In 2008,
we filed 29 foreign patent applications.  In 2007, we filed ten U.S.
and two foreign patent applications.  During 2006, we filed three U.S.
and five foreign patent applications.
 
 As of
December 31, 2008, we held 192 patents and an extensive library of performance
data and technological know-how.  We have patent coverage in North
America, Europe, Asia and South America.  Our patent portfolio as of
December 31, 2008 includes 27 U.S. patents and 165 corresponding foreign patents
along with 127 pending U.S. and foreign patent applications.  We
continue to make invention disclosures for which we are in the process of
preparing patent applications.  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.
 
 We have
made substantial investments in our technology and intellectual property and
have incurred development costs for engineering prototypes, pre-production
models, verifications by U.S. Environmental Protection Agency (EPA) and others
and field-testing of several products and applications.  Our
intellectual property strategy has been to build upon our base of core
technology that we have developed or acquired with newer advanced technology
patents developed by 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 the core
patents.
  4
 Table of Contents
  
 Our core
patents, advanced patents and patent applications cover the means of controlling
the principal emissions from diesel engines:
 
 ·
                nitrogen
      oxides (NOx);
 ·
                particulate
      matter (PM);
 ·
                carbon
      monoxide (CO);
 ·
                hydrocarbon
      (HC); and
 ·
                carbon
      dioxide (CO2).
 
 Our core
patents, advanced patents and patent applications include the
following:
 
 ·
              Fuel-borne
      catalysts;
 ·
              Selective
      catalytic reduction;
 ·
              Catalyzed
      wire mesh diesel particulate
filters;
 ·
              Biofuels;
      and
 ·
              Emission
      control systems.
 
 Our key
technologies include the following:
 
 ·
              The
      cost effective means of controlling the principal emissions from diesel
      engines (nitrogen oxides, particulate matter, carbon monoxide and
      hydrocarbon).
 ·
              Reduction
      of carbon dioxide and other greenhouse gas emissions by enhancing
      combustion efficiency and by enabling long-term reliable performance of
      emission control systems.
 ·
              Effective
      utilization of strategic catalytic materials such as platinum enables
      reduced emission control system costs, recycling strategies and low
      nitrogen dioxide emission levels.
 ·
              Low
      cost, reliable and durable diesel particulate filter performance through
      catalyzed wire mesh filter systems in retrofit
    applications.
 
 Protecting
our intellectual property rights is costly and time consuming.  We
incur patent-related expenses for patent filings, prosecution, maintenance and
annuity fees which amounted to $227,000, $364,000 and $235,000 for the years
ended December 31, 2008, 2007 and 2006, respectively.  We incur
maintenance fees to maintain our granted U.S. patents and annuity fees to
maintain foreign patents and the pending patent applications.
 
 We rely
on a combination of patent, trademark, copyright and trade secret protection in
the U.S. and elsewhere as well as confidentiality procedures and contractual
provisions to protect our proprietary technology.  Further, we enter
into confidentiality and invention assignment agreements with our employees and
confidentiality agreements with our consultants and other third
parties.  There can be no assurance that pending patent applications
will be approved or that the issued patents or pending applications will not be
challenged or circumvented by competitors.  Certain critical
technology incorporated in our products is protected by patent laws, trade
secret laws, confidentiality agreements and licensing
agreements.  There can be no assurance that such protection will prove
adequate or that we will have adequate remedies for disclosure of the trade
secrets or violations of the intellectual property rights.
 
 Business
Strategy
 
 Our
strategy is to maximize our revenue by penetrating the diesel emission reduction
market to the greatest extent possible.  To achieve this objective, we
will use licensing agreements with OEMs, Tier One suppliers, retrofit system
integrators and other suppliers.  Our standard licensing agreements
are structured so that we derive revenue from license fees and on-going
royalties.  In 2009, we will seek broader market coverage by not only
strengthening our marketing and distribution channels but also stressing value
propositions that highlight our unique environmental benefits, fuel economy
improvements and practical, lower cost emission control.  We intend to
spur the market demand for current and potential licensees and ensure that the
full value of our technology is realized by the end user.
 
 Solutions
and Products
 
 We have
succeeded in developing technologies and products that, when combined with other
after-treatment devices, reduce particulates and nitrogen oxides emissions from
diesel engines to or below the U.S. and international regulated emission levels,
while also improving fuel economy.  This results in a reduction in
fuel costs and greenhouse gas emissions, primarily carbon dioxide, as well as a
reduction in emissions of particulate matter, nitrogen oxides, carbon monoxide
and unburned hydrocarbons.
  5
 Table of Contents
  As
described below, our products and solutions include the Platinum Plus fuel-borne
catalyst; ARIS®, an
advanced reagent injection system used in selective catalytic reduction systems
for control of emissions of nitrogen oxides from diesel engines and for
hydrocarbon injection applications; diesel particulate filter technology based
on catalyzed wire mesh filter elements; and biofuels technology including
Biodiesel PlusTM.
 
 Platinum
PlusFuel-Borne
Catalyst
 
 We have
developed and patented our Platinum Plus fuel-borne catalyst as a diesel fuel
soluble additive, which contains minute amounts of organo-metallic platinum and
cerium catalysts.  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.  Thus, 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.
 
 Field
trials in 2008 using Platinum Plus fuel-borne catalyst demonstrated improvement
in fuel economy from 9% to 12%.  Our Platinum Plus fuel-borne catalyst
can be used alone with diesel fuels, from regular to ultra-low sulfur diesel, as
well as biodiesel fuel blends; to reduce particulate emissions by 10% to 25%
from the engine, while also improving the performance of diesel oxidation
catalysts and particulate filters.  Use of fuel-borne catalysts also
keeps particulate filters cleaner by burning off the soot particles at lower
temperatures and further reducing toxic emissions of carbon monoxide and
unburned hydrocarbons.  Platinum Plus has also been shown to provide
energy efficiency and emissions reduction benefits when applied with two-stroke
gasoline powered engines, including those commonly used in Asian
markets.
 
 Through
our strategic use of independent test laboratories from 1996 to the present, we
have conducted research and development programs on platinum fuel-borne
catalysts which were conducted by Delft Technical University (Netherlands),
Ricardo Consulting Engineers (U.K.), Cummins Engine Company (U.S.), West
Virginia University (U.S.), the Technical University of Dresden (Germany) and
Southwest Research Institute (U.S.).  This approach allows our
technical team to execute programs on a cost effective basis while bringing in a
wide range of expertise.  Most importantly, the results have been
independently derived.
 
 We
received EPA registration in December 1999 for the Platinum Plus fuel-borne
catalyst for use in bulk fuel by refiners, distributors and
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 July 2008, the EPA released a general
statement regarding emissions from platinum-based fuel additives which indicated
that the EPA is evaluating available emissions data and health effects studies
in an effort to assess potential health risks associated with platinum- or
cerium-based fuel additives.  We are cooperating with the EPA to plan
and conduct further definitive testing with respect to these questions, which
testing costs we have included in our 2009 budget.
 
 Platinum
Plusfor
Diesel Emission Reduction
 
 The
Platinum Plus fuel-borne catalyst can be used alone with all diesel fuels,
including regular sulfur diesel, ultra-low sulfur diesel, arctic diesel
(kerosene) and biodiesel fuels to reduce particulate emissions by 10% to
25%.  Environmentally conscious corporations and fleets can utilize
this solution to voluntarily reduce emissions while obtaining an economic
benefit.
 
 We
received the EPA’s Environmental Technology Verification in 2003 for our
Platinum Plus fuel-borne catalyst and a diesel-oxidation catalyst (the Platinum
Plus “Purifier e2 System”) for pre-1996 manufactured engines, which are higher
emitters of particulates and nitrogen oxides than newer engines, as well as
verification extension for our fuel-borne catalysts with diesel-oxidation
catalysts to cover engines manufactured between 1994 and 2003.  We
were recognized early as a company making enabling, cost-effective emission
reduction technologies available for the retrofit market.  Effective
January 1, 2009, the EPA adopted new regulations for nitrogen dioxide (NO2)
emissions testing, now harmonized with the newly implemented California Air
Resources Board (CARB) requirements.  We provided a dossier of
information to the EPA based on our prior testing to demonstrate the low NO2
performance features of this verified product.  Although the test
results were positive, EPA determined that further testing in accordance with
the new protocols was required to restore the verified status.  We are
cooperating with the EPA in evaluating the requirements for a new testing and
verification program in accordance with the new EPA and CARB
protocol.  Until satisfactorily completing test programs to meet these
EPA requirements, our verification status has been moved by the EPA to the
“Formerly Verified Systems” section of the EPA website.  We do not
believe this has a material impact on our business.
  6
 Table of Contents
  Diesel
particulate filters trap up to 95% of the exhaust particulate matter but, in
doing so, can become clogged with carbon soot.  Use of fuel-borne
catalysts reduces the amount of particulate matter which the filter is exposed
to, and further reduces emissions of toxic carbon monoxide and unburned
hydrocarbons.  Our fuel-borne catalyst also significantly lowers the
temperature at which the captured soot will burn, thereby allowing the
particulate filters to regenerate themselves and stay cleaner during a wider
range of operating conditions.
 
 Platinum
Plus fuel-borne catalyst is increasingly utilized as a diesel particulate filter
regeneration additive.  In Europe, it is currently being supplied into
the U.K., Denmark, Belgium, Switzerland, Sweden, Austria and Holland markets
through distribution sources for aftermarket retrofit
applications.  The Platinum Plus fuel-borne catalyst has also found
application in the U.K. to alleviate soot blocking from light drive cycle bus
applications.  In Asia, we are conducting field trials and developing
relationships with Asian distributors to fully exploit this growing
market.  In the U.S., the Platinum Plus fuel-borne catalyst has been
accepted for use by the Mine Safety and Health Administration in underground
mines and has been successfully used as a regeneration aid for vehicles fitted
with lightly catalyzed diesel particulate filters.
 
 Furthermore,
in the passenger car market where fuel-borne catalyst technology dominates the
diesel particulate filter regeneration market, engine testing conducted most
recently in 2006 at a European testing institute reconfirmed the ability to
reduce total platinum usage of an emission control device by up to 70%, thus,
offering significant cost saving for passenger car manufacturers.
 
 Platinum
PlusforFuel
Economy
 
 We
believe that recent volatility in the cost of fuel has made the economic impact
of greater fuel economy an important consideration in many
industries.  Further, recent media focus on global warming and the
effects of fuel consumption on the environment has resulted in an increased
interest in Platinum Plus fuel-borne catalyst from a standpoint of corporate
social responsibility.  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 (dependent on the amount of platinum that
gets introduced into the engine, which period varies by the surface area of the
motor), 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 $0.81 per
U.S. gallon.  In other words, at or above that level, the economic
benefit our customers derive from use of our Platinum Plus fuel-borne catalyst
exceeds the cost of the additive.  When coupled with the demand to
reduce carbon dioxide emissions from transportation and distributed power
generation, the argument for use of Platinum Plus is a persuasive
one.
 
 In 2008,
we conducted fuel economy field trials for the purpose of demonstrating the fuel
economy benefits and emission reduction attributable to Platinum Plus fuel-borne
catalyst.  The improvement in fuel economy from using Platinum Plus
fuel-borne catalyst in these field demonstrations for rail and on-road fleets
was from 9% to 12%.
 
 Platinum
Plusfor
Biodiesel
 
 When used
with blends of biodiesel and ultra-low sulfur diesel, our Biodiesel PlusTM
product, 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.  This enables
biodiesel producers to differentiate and offer a premium biodiesel with reduced
environmental impact and improved performance.  The biodiesel market
is still in its infancy and is expected to expand over the next several
years.
  7
 Table of Contents
  ARIS
Selective Catalytic Reduction
 
 The ARIS
(Advanced Reagent Injection System) is our patented airless, return-flow system
for the injection of reducing reagents for such applications as the low NOx
trap, active diesel particulate filter regeneration, and selective catalytic
reduction.  The primary use of the ARIS system to date has been in
conjunction with selective catalytic reduction for both stationary diesel
engines for power generation and mobile diesel engines used in
transportation.  The system is comprised of our patented single fluid
computer-controlled injector that provides precise injection of nontoxic
urea-based reagents into the exhaust of a stationary or mobile engine, where the
system then converts harmful nitrogen oxides across a catalyst to harmless
nitrogen and water vapor.  The system works well with various reagents
including hydrocarbon and has shown reduction of nitrogen oxides of up to 90% on
a steady-state operation and of up to 85% in transient
operations.  This process, known as selective catalytic reduction, has
been in use for many years in power stations, and it is well proven in mobile
and stationary applications.  The ARIS system is a compact version of
the selective catalytic reduction injection system.  A principal
advantage of the patented ARIS system is that compressed air is not required to
operate the system and that a single fluid is used for both nitrogen oxides
reduction and injector cooling.  The system is designed for
high-volume production and is compact, with very few components, making it
inherently cheaper to manufacture, install and operate than the compressed air
systems, which were first developed for heavy-duty engines.  ARIS
technology is applicable for reduction of nitrogen oxides from all combustion
engine types, ranging from passenger car and light duty to large scale
reciprocating and turbine engines, including those using gaseous fuels such as
liquefied petroleum gas and compressed natural gas.
 
 Combined
Use of EGR and SCR
 
 As legislation tightens across the
globe, exhaust gas recirculation in combination with selective catalytic
reduction is becoming the preferred solution to meet strict nitrogen oxides
(NOx) levels.  Once considered competing solutions, we recognized the
benefits of combining these technologies to achieve very high levels of
emissions reduction with maximum fuel economy.  EGR can be activated
to reduce NOx when starting a cold engine, whereas SCR operates at higher
temperature when its catalyst is fully active, and at low EGR
rates.  With both EGR and SCR in place, engine systems can be
fine-tuned to optimize fuel efficiency together with emissions
reduction.  We have intellectual property holdings for the design and
implementation of these systems.  Most heavy duty manufacturers in the
U.S. have now announced their intentions to meet new regulations using the
combination of EGR-SCR.  Several leading providers to the industry
have already licensed this patent from us.  We are launching a new
program to offer commercial licenses to vehicle manufacturers and other
suppliers, and conveying to them the rights to practice this patented innovation
from the Company.
 
 Catalyzed
Wire Mesh Diesel Particulate Filter
 
 The
catalyzed wire mesh filter technology was initially developed by Mitsui Co.,
Ltd. for use in conjunction with our fuel-borne catalyst as a lower cost and
reliable alternative to the traditional heavily catalyzed filter
systems.  It also provides lower nitrogen dioxide emissions levels
relative to traditional, heavily catalyzed filter systems.  The
catalyzed wire mesh filter technology was transferred to us under a technology
transfer agreement with Mitsui and PUREarth in 2005.  Under the
agreement, we acquired the worldwide title (excluding Japan) to the patents and
other intellectual properties.  The catalyzed wire mesh filter
technology is designed for use in a wide range of diesel engine particulate
emission control applications.
 
 We had
verified the system (“Purifier e3”) under the EPA’s Environmental Technology
Verification protocol in June 2004 as reducing toxic particulates by up to 76%,
carbon monoxide by 60%, hydrocarbons by 80% and nitrogen oxides by
9%.  Effective January 1, 2009, the EPA adopted new regulations for
NO2 emissions testing, now harmonized with the newly implemented CARB
requirements.  We provided a dossier of information to the EPA based
on our prior testing to demonstrate the low NO2 performance features of this
verified product.  Although the test results were positive, EPA
determined that further testing in accordance with the new protocols was
required to restore the verified status.  We are cooperating with the
EPA in evaluating the requirements for a new testing and verification program in
accordance with the new EPA and CARB protocol.  Until satisfactorily
completing test programs to meet these EPA requirements, our verification status
has been moved by the EPA to the “Formerly Verified Systems” section of the EPA
website.
 
 The
catalyzed wire mesh filter technology is a durable, low-cost filter designed to
bridge the gap between low efficiency diesel-oxidation catalysts and expensive,
heavily catalyzed wall-flow particulate filters.  The wire-mesh filter
system is designed to work synergistically with a fuel-borne catalyst for
reliable performance on a wide range of engines and with a broad range of
fuels.  This combined Platinum Plus fuel-borne catalyst/catalyzed wire
mesh filter technology is especially suited to solving the challenging problem
of delivering a reliable pollution control solution which can be easily
retrofitted for the older, higher-emission diesel engines expected to be in
service for years to come, and in markets and applications where ultra-low
sulfur diesel is not available.
  8
 Table of Contents
  In
addition to reducing the cost to achieve these emission reductions, the patented
combination with a fuel-borne catalyst permits the catalyzed wire mesh filter to
operate effectively at the lower exhaust temperatures found in many stop-and-go
service applications.  The fuel-borne catalyst reduces emissions and
allows soot captured in the catalyzed wire mesh filter to be reliably combusted
at lower exhaust temperatures.  Commercial systems of Platinum Plus
fuel-borne catalyst with this durable catalyzed wire mesh filter have
demonstrated performance in buses, delivery vehicles, refuse trucks, cranes and
off-road equipment.
 
 The
Market and the Regulatory Environment
 
 We
estimate that worldwide annual consumption of diesel fuel exceeds 260 billion
U.S. gallons, including approximately 53 billion in the U.S., 66 billion in
Europe and 78 billion in Asia.
 
 New
Diesel Engines
 
 While
engine manufacturers have traditionally met emissions regulations by engine
design changes, we believe that further reduction in emissions can be achieved
best by using combinations of cleaner-burning fuels and after-treatment systems
such as diesel-particulate filters and catalytic systems for reducing nitrogen
oxides.  Like many of the engine-based emissions control strategies,
these also generally increase fuel consumption.  The use of our
technologies decreases fuel consumption relative to the
alternatives.
 
 Emissions
regulations for new mobile diesel engines in the major markets of North America,
Europe and Asia have continued to tighten and are now 40% to 90% lower than
previous regulations.  Regulations in effect by 2010 in the U.S. and
by 2009 in Europe and in Asia are expected to reduce the emissions level for new
mobile diesel engines from 85% to 99% of the levels mandated in the
mid-1980s.  Management expects the market for nitrogen oxide reduction
systems in mobile applications to develop between 2009 and
2010.  European engine manufacturers decided to use urea selective
catalytic reduction in 2006, beginning with heavy-duty vehicles and likely for
use on medium and light vehicles and passenger cars, as well.  There
is a clear preference to use a single fluid system for the medium and light
trucks, passenger cars and SUVs which have no compressed air
system.  It also seems likely that European manufacturers will adopt
particulate filters to meet 2009 regulations which have been ratified by the
European Parliament.  We have intellectual property holdings for the
design and implementation of these systems.
 
 In the
non-road sector, new regulations stemming from EPA proposals first made in 2004,
will be phased in from 2008 to 2014.  Targeted vehicles include a wide
range of construction equipment and agricultural equipment, as well as railroad
and marine applications.
 
 We
believe the U.S. market for diesel engines is poised for growth due to favorable
fuel economy performance of diesel engines, coupled with the increased ability
to reduce particulate matter and emissions of nitrogen oxides from such
engines.  Europe and Asia already use significantly more mobile diesel
engines than the U.S., particularly for passenger and light-duty
vehicles.  Engine manufacturers have all employed particulate filters
to meet U.S. heavy-duty diesel vehicle regulations effective for the 2007 model
year and have indicated their intent to continue this for particulate matter
control in 2010.  Major U.S. and European engine manufacturers have
committed to adopt urea selective catalytic reduction.  We believe
that both particulate filters and nitrogen oxides control technology will be
required in Europe and the U.S. in the 2009 to 2010 timeframe.
 
 Existing
Diesel Engines and the Retrofit Market
 
 While
much of the regulatory pressure and resulting action from engine manufacturers
has focused on reducing emissions from new engines, there is increasing concern
over pollution from existing diesel engines, many of which have from 20- to
30-year life cycles.  The EPA has estimated that in the U.S. alone
there are approximately 11 million diesel powered vehicles which need to be
retrofitted over the next ten years.  There is growing interest in the
potential market that may exist for retrofitting diesel engines with emissions
reduction systems.  Stationary diesel engines, construction equipment
and public transportation vehicles such as buses and commercial and municipal
truck fleets will all be included in such a retrofit diesel engine
market.
  9
 Table of Contents
  The
California Air Resources Board declared diesel particulates to be toxic in 1998,
and in 2000, it proposed reductions in particulate emissions from over one
million existing engines in California as well as more stringent controls for
new engines.  The EPA stated its objective for retrofitting vehicles
with particulate controls and developed the Clean School Bus U.S.A. program and
the Smartway Transport Program to reduce both diesel emissions and fuel
consumption on over-the-road trucks and buses.
 
 Competition
 
 Because
our principal strategy is the licensing of our technologies, those companies
that could be considered as competitors should also be considered as our
potential customers.
 
 We face
direct competition from companies with far greater financial, technological,
manufacturing and personnel resources, including BASF (formerly Engelhard),
Donaldson, Cummins Filtration, Innospec (formerly Octel), Oxonica, Rhodia and
Johnson Matthey.  We also face indirect competition in the form of
alternative fuel consumption vehicles such as those using methanol, hydrogen,
ethanol and electricity.
 
 We
believe that our technologies and products occupy a strong competitive position
relative to others in the diesel emissions reduction technology
market.  Competition in EPA verified, or formerly verified,
particulate reduction systems for retrofit is from catalyst systems suppliers
like Johnson Matthey and BASF.  These companies employ systems that
rely on much greater quantities of platinum than we do and that have the
undesirable effect of increasing emissions of nitrogen dioxide, a component of
nitrogen oxides and a strong lung irritant.  Competition in the diesel
fuel additive market is from additive suppliers such as Innospec and Rhodia, who
market an iron-based product, and Oxonica, who markets a cerium product for fuel
economy improvement.  Our EPA-registered Platinum Plus fuel-borne
catalyst provides fuel economy benefits as it competes on performance in
regenerating filters and lowering system cost for the system provider by
enabling reduced platinum levels and lower overall metal usage which results in
less ash buildup on filters.  Platinum Plus fuel-borne catalyst also
offers better performance in terms of carbon monoxide and hydrocarbon
reduction.  Finally, in the nitrogen oxides control market,
competition is from other suppliers of reagent-based post-combustion nitrogen
oxides control systems such as Johnson Matthey (including Argillion which it
acquired in 2007), Hilite International and KleenAir Systems for retrofit, and
Bosch and Hilite International for OEMs.  Each of Bosch and Hilite has
a worldwide, non-exclusive technology license agreement with us for the right to
use our proprietary technology for a single fluid system which requires no
compressed air.
 
 Market
Opportunity
 
 We
believe our technologies are applicable to all existing diesel engines, all new
engines designed to meet upcoming emission standards and all types of fuel,
including biodiesel and ultra-low sulfur diesel.  We view the market
opportunity as one that may be divided by application and market
drivers.  Because of the financial benefit of improved fuel economy
along with reduction of greenhouse gases, we have continued to emphasize fuel
economy in the markets we serve.
 
 Our
intellectual property and technologies are now at the center of developments in
the on-road diesel market.  Selective catalytic reduction which
utilizes our ARIS technology and diesel particulate filtration which can utilize
our Platinum Plus technology are core technologies to the development of the
pending generation of cleaner diesels.  We believe this places us in a
strong position going forward.  To meet 2010 requirements, some
alternative fuels’ strategies will also need to consider means of reducing
nitrogen oxides emissions.  Current projects are demonstrating the
effective application of our ARIS-based systems with these alternative fuels’
vehicles.
 
 The two
principal market drivers for our products are legislative compliance for
emission control and fuel economy improvement.  Platinum Plus
fuel-borne catalyst is an “enabling technology” that enables emission reductions
from the engine itself and enhances performance of the exhaust after-treatment
systems while improving fuel economy.  The continued tightening of
clean air standards, emissions control regulations, pressure for fuel efficiency
and growing international awareness of the greenhouse effect should provide us
with substantial opportunities in local markets throughout North America, Europe
and Asia.
  10
 Table of Contents
  Without
compromising the fuel economy benefits of diesel, a significant reduction of
particulate and nitrogen oxides emissions can only be achieved by using
combinations of improved engine design, cleaner burning fuels and
after-treatment systems such as diesel particulate filters and catalytic
systems.  The Platinum Plus fuel-borne catalyst (which improves
combustion catalytically and enables higher performance of exhaust treatment
devices) and the ARIS selective catalytic reduction technology can form key
components of both of these after-treatment systems.
 
 The
convergence of greater interest in regulated and greenhouse gas emissions
reduction and economic benefit of our products makes the use of our products an
attractive benefit to end-users.  Our Platinum Plus fuel-borne
catalyst in field trials during 2008 showed 9% to 12% fuel economy
improvement.  In Europe, where diesel fuel retails in some countries
for as much as four times the U.S. selling price because of the higher tax rate
on fuels, potential fuel economy benefits are even more pronounced.
 
 Marketing
Strategy and Commercialization
  After-treatment
systems for emissions reduction from diesel engines are now penetrating the
diesel market.  The introduction of selective catalytic reduction in
Europe and Japan for heavy-duty applications and the move to include diesel
particulate traps for diesel passenger cars has confirmed our technology as
central to the diesel market.  PSA Peugeot has taken the lead and
offers particulate filter systems with fuel-borne catalysts on several of its
models.  Other manufacturers such as Volkswagen and Daimler Benz offer
diesel particulate filters for their larger vehicles.  In the U.S.,
Daimler Benz is now promoting the “clean diesel” passenger car under the
“Bluetec” brand name which uses selective catalytic reduction to achieve the
high nitrogen oxides reduction standards and will likely use airless urea
injection.
 
 The EPA
and California Air Resources Board programs are accelerating the activities
toward creation of active markets for diesel emissions reduction technologies
and products in the U.S.  These markets include applications for new
vehicles from 2007 onward and retrofit applications in on- and off-road
segments, as well as for stationary power generation.  Thus, the
market for diesel emissions reduction technologies and products is still
emerging.  We expect growing demand for diesel emissions reduction
technologies and products for the diesel engine market, owners of existing
fleets of diesel-powered vehicles, and expanding requirements from the off-road,
marine and railroad sectors.  At the same time, engine OEMs are
looking to subsystem suppliers to provide complete exhaust subsystems including
particulate filters and/or nitrogen oxides abatement systems and eventually
both.
 
 It is an
essential requirement of the U.S. retrofit market that emissions control
products and systems are verified under the EPA and/or California Air Resources
Board protocols to qualify for credits within the EPA and/or California Air
Resources Board programs.  Funding for these emissions control
products and systems is generally limited to those products and technologies
that have already been verified.  As of the date of this report, we do
not have EPA verifications which may disadvantage us in attracting customers
with access to governmental funding for retrofit programs.  In 2009,
we intend to verify our Platinum Plus fuel-borne catalyst in combination with a
high performance diesel particulate filter and may also seek to verify our
Platinum Plus fuel-borne catalyst with additional emissions control devices
manufactured by other vendors.  We may receive recurring revenue from
sales of such systems or devices in the event sales of these devices include the
Platinum Plus fuel-borne catalyst product as part of the devices’
verification.
 
 We
currently manufacture and ship the Platinum Plus fuel-borne catalyst product
from a toll blender in the U.S., a toll blender in the U.K. and from a warehouse
in the U.S.  However, as demand for the product increases, we intend
to expand the manufacturing and distribution by supplying platinum concentrate
to third parties with U.S. and foreign facilities pursuant to licensing
agreements so that these licensees may market the finished Platinum Plus
fuel-borne catalyst products to fuel suppliers and end users.
 
 We have
entered into non-exclusive worldwide license agreements for our ARIS nitrogen
oxides reduction technology.  We believe this strategy of licensing
the products and technologies represents the most efficient way to gain
widespread distribution quickly and to exploit demand for the
technologies.
 
 We intend
to utilize our catalyzed wire mesh filter technology by selling products based
upon that technology alone and in combination with our Platinum Plus fuel-borne
catalyst.  We developed patent applications in cooperation with
external research institutions, which are intended to expand the market uses of
the catalyzed wire mesh-based diesel particulate filter
technology.
  11
 Table of Contents
  Health
Effects, Environmental Matters and Registration of Additives
 
 We are
subject to environmental laws in all the countries in which we do
business.  Management believes that the Company is in compliance with
applicable laws, regulations and legal requirements.
 
 Engine
tests in the U.S. and Switzerland show that, when used in conjunction with a
diesel particulate filter, from 99% to 99.9% of the Platinum Plus catalyst metal
introduced to the fuel system by the fuel-borne catalyst is retained within the
engine and exhaust and that the amount of platinum emitted from the use of
Platinum Plus fuel-borne catalyst is roughly equivalent to platinum attrition
from automotive and diesel catalytic converters.
 
 Metallic
fuel additives have come under scrutiny for their possible effects on
health.  We registered our platinum additive in 1997 in both the U.S.
and the U.K.  The platinum-cerium bimetallic additive required further
registration in the U.S. that involved a 1,000-hour engine test and extensive
emission measurements and analysis.  The registration of the
platinum-cerium bimetallic additive was completed in 1999 and issued in December
1999.
 
 Germany,
Austria and Switzerland have set up a protocol (VERT) for approving diesel
particulate filters and additive systems used with them.  We completed
the required tests under the VERT protocol in 2000 and in January 2001, the
Swiss authority BUWAL approved our Platinum Plus fuel-borne catalyst fuel
additive for use with a diesel particulate filter.
 
 The U.K.
Ministry of Health’s Committee on Toxicity reviewed our Platinum Plus product
and all the data submitted by us in December 1996 and stated, “The Committee is
satisfied that the platinum emission from vehicles would not be in an allergenic
form and that the concentrations are well below those known to cause human
toxicity.”  Radian Associates, an independent research consulting
firm, reviewed our data and the literature on platinum health effects in 1997
and concluded, “The use of Clean Diesel Technologies’ platinum containing diesel
fuel additive is not expected to have an adverse health effect on the population
under the condition reviewed.”  Radian Associates also concluded that
emissions of platinum from the additive had a margin of safety ranging from
2,000 to 2,000,000 times below workplace standards.
 
 The U.S.
Mining Safety and Health Administration accepted the use of Platinum Plus
fuel-borne catalyst with particulate filters in 2002, and also allowed its use
in all fuel used in underground mining, even without filters.
 
 In 2009,
we intend to file with the EPA completed third-party evaluations regarding
secondary emissions from our fuel-born catalyst.  We initiated
independent tests in 2005 to address questions from the EPA on the use of our
fuel-borne catalyst resulting from growing commercial interest in its diesel
emission control products.  The results from testing of our Platinum
Plus fuel-borne catalyst over eight months at laboratories recognized and
approved by the EPA confirmed that any potentially allergenic platinum emissions
from the use of the Platinum Plus fuel-borne catalyst were hundreds to thousands
of times below the lowest published safe level and were consistent with reported
platinum emissions from catalyzed control devices, in the opinion of the
scientists.
 
 Revenue
 
 We
generate revenue from product sales comprised of fuel-borne catalysts, including
our Platinum Plus fuel-borne catalyst products and concentrate, and hardware
(primarily, our patented ARIS advanced reagent injector and dosing systems for
selective catalytic reduction of nitrogen oxides, our Platinum Plus Purifier
System, our fuel-borne catalyst and a diesel-oxidation catalyst, and catalyzed
wire mesh filters, including catalyzed wire mesh filters used in conjunction
with our Platinum Plus fuel-borne catalyst); license and royalty fees from the
ARIS system and other technologies; and consulting fees and other (primarily,
engineering and development consulting services).  The following table
sets forth the percentage contribution of our revenue sources in relation to
total revenue for the years ended December 31, 2008, 2007 and
2006.
  12
 Table of Contents
  
 (in
      thousands)For the years ended December
      31,2008
                    
                    
                    2007
                    
                    
                    2006Product
      sales
                    
                    $
                    7,024
                    
                    
                    
                    94.0%
                    
                    
                    $
                    1,466
                    
                    
                    
                    29.8%
                    
                    
                    $
                    860
                    
                    
                    
                    76.6%License
      and royalty revenue
                    
                    
                    451
                    
                    
                    
                    6.0%
                    
                    
                    
                    3,459
                    
                    
                    
                    70.2%
                    
                    
                    
                    74
                    
                    
                    
                    6.6%Consulting
      and other
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    189
                    
                    
                    
                    16.8%Total
                    
                    $
                    7,475
                    
                    
                    
                    100.0%
                    
                    
                    $
                    4,925
                    
                    
                    
                    100.0%
                    
                    
                    $
                    1,123
                    
                    
                    
                    100.0%
 
 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.  To date, we have been dependent
on a few customers for a significant portion of our revenue (see “Significant
Customers” in Note 2 of Notes to Consolidated Financial
Statements).  The geographic areas from which our revenue was
recognized for the years ended December 31, 2008, 2007 and 2006 are outlined in
Note 14 of Notes to Consolidated Financial Statements.
 
 Our
Platinum Plus fuel-borne catalyst concentrate and finished product are sold to
distributors, resellers and various transportation segments, including on-road,
off-road, rail and marine, among other end users.  Our products and
solutions are sold to customers through our distribution network, direct sales
and the efforts of our sales consultants and agents.  We license the
ARIS nitrogen oxides reduction system and the combination of EGR with SCR to
others, generally with an up-front fee for the technology and know-how transfer
and an on-going royalty per unit.  We also sell finished ARIS-based
selective catalytic reduction systems to potential ARIS licensees and end
users.  We believe that the ARIS system can most effectively be
commercialized through licensing several companies with a related business in
these markets.  We are actively seeking additional ARIS licensees for
both mobile and stationary applications in the U.S., Europe and
Asia.  We offer rights to the catalyzed wire mesh technology through
license agreements as well as selling finished filters for use with our Platinum
Plus fuel-borne catalyst.
 
 Sources
of Supply
 
 Platinum and cerium are the principal
raw materials used in the production of the Platinum Plus fuel-borne catalystandaccount for a substantial portion ofour productcosts. These metals are generally available
frommultiple
sources,and webelieve the sources of these are
adequate for our current operations.The cost of platinum or the processing
cost associated with converting the metal may have a direct impact on the future
pricing and profitability ofourPlatinum Plusfuel-borne catalyst.We have a strategy of passing our cost
increases along to our customers and have identified opportunities to lower the
lifetime platinum cost within the overall system cost.We do not anticipate a shortage in the
supply of the raw materials used in the production of thefuel-borne catalystin the foreseeable
future.  While we have outsourcing arrangements with two companies in
the precious metal refining industry to procureplatinum, there are no fixed commitments with
these parties to provide supplies, and we may make procurement arrangements with
others to fulfillourraw materials
requirements.We also have ample licensed
and qualified manufacturers for the manufacture on our behalf of hardware
components, catalysts, filters and electronics.
 
 Research
and Development
 
 We
anticipate that we will continue to make significant research and development
expenditures to maintain and expand our competitive position.  This
includes improving our current technologies and products and developing and
acquiring newer technologies and products.
 
 Our
research and development costs include verification programs, evaluation and
testing projects, salary and benefits, consulting fees, materials and testing
gear and are charged to operations as they are incurred.  Our research
and development expenses, exclusive of patent costs, totaled approximately
$430,000, $428,000 and $510,000, respectively, for the years ended December 31,
2008, 2007 and 2006.
 
 Insurance
 
 We
maintain coverage for the customary risks inherent in our
operations.  Although we believe our insurance policies to be adequate
in amount and coverage for current operations, no assurance can be given that
this coverage will be, or continue to be, available in adequate amounts or at a
reasonable cost, or that such insurance will be adequate to cover any future
claims.
  13
 Table of Contents
  Employees
 
 As of
March 1, 2009, we had 19 full-time employees and two part-time
employees.  We also retain outside consultants, including sales and
marketing consultants and agents.  As of March 1, 2009, our sales and
marketing team consisted of nine employees, sales consultants and agents
supported by our executive officers and members of our Board of
Directors.
 
 We enjoy
good relations with our employees and are not a party to any labor management
agreements.
 
 Available
Information
 
 We file
reports, proxy statements and other documents with the Securities and Exchange
Commission ("SEC").  You may read and copy any document we file with
the SEC at the SEC's public reference room at 100 F Street, N.E., Washington,
D.C. 20549.  You should call 1-800-SEC-0330 for more information on
the public reference room.  Our SEC filings are also available to you
on the SEC's Internet site at http://www.sec.gov.
 
 We
maintain an Internet site at http://www.cdti.com/.  The information
posted on our website is not incorporated into this Annual Report on Form
10-K.
 
 
 Item1A.
              Risk
      Factors
 
 Set forth below are the risks that we
believe are material to our investors.  This section contains
forward-looking statements.  You should refer to the explanation of
the qualifications and limitations on forward-looking statements set forth at
the beginning of Item 1 of this Annual Report.
 
 Risks
Related to Regulatory Matters
 
 We
face constant changes in governmental standards by which our products are
evaluated.
 
 We
believe that, due to the constant focus on the environment and clean air
standards throughout the world, a requirement in the future to adhere to new and
more stringent regulations both domestically and abroad is possible as
governmental agencies seek to improve standards required for certification of
products intended to promote clean air.  In the event our products
fail to meet these ever-changing standards, some or all of our products may
become obsolete.
 
 Future
growth of our business depends, in part, on successful verification of our
products and retention of our verifications.
 
 We
believe that it is an essential requirement of the U.S. retrofit market that
emissions control products and systems are verified under the EPA and/or
California Air Resources Board protocols to qualify for credits within the EPA
and/or California Air Resources Board programs.  Funding for these
emissions control products and systems is generally limited to those products
and technologies that have already been verified.  In 2009, we intend
to verify our Platinum Plus fuel-borne catalyst in combination with a high
performance diesel particulate filter with California Air Resources
Board.  We have no assurance that our product will be verified by
California Air Resources Board or that such a verification will be acceptable to
the EPA.  Verification is also useful for commercial
acceptability.
 
 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.
  14
 Table of Contents
  Future growth of our business
depends, in part, on enforcement of existing emissions-related environmental
regulations and further tightening of emission standards worldwide.
 
 We expect
that the future business growth will be driven, in part, by the enforcement of
existing emissions-related environmental regulations and tightening of emissions
standards worldwide.  If such standards do not continue to become
stricter or are loosened or are not enforced by governmental authorities, it
could have a material adverse effect on our business, operating results,
financial condition and long-term prospects.
 
 New
metal standards, lower environmental limits or stricter regulation for health
reasons of platinum or cerium could be adopted and affect use of our
products.
 
 New
standards or environmental limits on the use of platinum or cerium metal by a
governmental agency could adversely affect our ability to use our Platinum Plus
fuel-borne catalyst in some applications.  In addition, California Air
Resources Board requires “multimedia” assessment (air, water, soil) of the
fuel-borne catalyst.  The EPA could require a “Tier III” test of the
Platinum Plus fuel-borne catalyst at any time to determine additional health
effects of platinum or cerium which tests may involve additional costs beyond
our current resources.
 
 Risks
Related to Our Business and Industry
 
 We
face competition and technological advances by competitors.
 
 There is
significant competition among companies that provide solutions for pollutant
emissions from diesel engines.  Several companies market products that
compete directly with our products.  Other companies offer products
that potential customers may consider to be acceptable alternatives to our
products and services.  We face direct competition from companies with
greater financial, technological, manufacturing and personnel
resources.  Newly developed products could be more effective and cost
efficient than our current or future products.  We also face indirect
competition from vehicles using alternative fuels, such as methanol, hydrogen,
ethanol and electricity.
 
 We
depend on intellectual property and the failure to protect our intellectual
property could adversely affect our future growth and success.
 
 We rely
on patent, trademark and copyright law, trade secret protection, and
confidentiality and other agreements with employees, customers, partners and
others to protect our intellectual property.  However, some of our
intellectual property is not covered by any patent or patent application, and,
despite precautions, it may be possible for third parties to obtain and use our
intellectual property without authorization.
 
 We do not
know whether any patents will be issued from pending or future patent
applications or whether the scope of the issued patents is sufficiently broad to
protect our technologies or processes.  Moreover, patent applications
and issued patents may be challenged or invalidated.  We could incur
substantial costs in prosecuting or defending patent infringement
suits.  Furthermore, the laws of some foreign countries may not
protect intellectual property rights to the same extent as do the laws of the
U.S.
 
 Some of
our patents, including a platinum fuel-borne catalyst patent, expired in
2008.  However, we believe that other longer lived patents, including
those for platinum and other fuel-borne catalyst materials in combination with
after-treatment devices, will provide adequate protection of our proprietary
technology, but there can be no assurance we will be successful in protecting
our proprietary technology.
 
 As part
of our confidentiality procedures, we generally have entered into nondisclosure
agreements with employees, consultants and corporate partners.  We
also have attempted to control access to and distribution of our technologies,
documentation and other proprietary information.  We plan to continue
these procedures.  Despite these procedures, third parties could copy
or otherwise obtain and make unauthorized use of our technologies or
independently develop similar technologies.  The steps that we have
taken and that may occur in the future might not prevent misappropriation of our
solutions or technologies, particularly in foreign countries where laws or law
enforcement practices may not protect the proprietary rights as fully as in the
U.S.
  15
 Table of Contents
  There can
be no assurance that we will be successful in protecting our proprietary
rights.  Any infringement upon our intellectual property rights could
have an adverse effect on our ability to develop and sell commercially
competitive systems and components.
 
 Our
results may fluctuate due to certain regulatory, marketing and competitive
factors over which we have little or no control.
 
 The
factors listed below, some of which we cannot control, may cause our revenue and
results of operations to fluctuate significantly:
 
 ·
              Actions
      taken by regulatory bodies relating to the verification, registration or
      health effects of our products.
 ·
              The
      extent to which our Platinum Plus fuel-borne catalyst and ARIS nitrogen
      oxides reduction products obtain market
  acceptance.
 ·
              The
      timing and size of customer
purchases.
 ·
              Customer
      concerns about the stability of our business which could cause them to
      seek alternatives to our solutions and
products.
 ·
              Increases
      in raw material costs, especially
platinum.
 
 An
extended interruption of the supply or a substantial increase in the price of
platinum could have an adverse effect on our business.
 
 The cost
of platinum or the processing cost associated with converting the metal may have
a direct impact on the future pricing and profitability of our Platinum Plus
fuel-borne catalyst.  The market price for platinum increased from
$480 per ounce in early 2002 to $965 per ounce at December 31, 2005, $1,120 per
ounce at December 31, 2006, $1,530 per ounce at December 31, 2007 and decreased
to $910 per ounce at December 31, 2008.  On January 30, 2009, the
London Metal Exchange afternoon fixing for platinum was $990 per
ounce.  Although we may minimize this risk through various purchasing
and hedging strategies, there can be no assurance that this will be
successful.  A shortage in the supply of platinum or a significant,
prolonged increase in the price of platinum, in each case, could have a material
adverse effect on our business, operating results and financial
condition.
 
 Failure
to attract and retain key personnel could have a material adverse effect on our
future success.
 
 Our
success will depend, in large part, on our ability to retain current key
personnel, attract and retain future key personnel, additional qualified
management, marketing, scientific, and engineering personnel, and develop and
maintain relationships with research institutions and other outside
consultants.  The loss of key personnel or the inability to hire or
retain qualified personnel, or the failure to assimilate effectively such
personnel could have a material adverse effect on our business, operating
results and financial condition.
 
 We
currently depend on the marketability of a limited number of primary products
and technologies, including Platinum Plus fuel-borne catalyst, ARIS advanced
reagent injection system for selective catalytic reduction, Purifier Systems and
catalyzed wire mesh filters.
 
 Our
Platinum Plus fuel-borne catalyst, ARIS advanced reagent injection system for
selective catalytic reduction, Purifier Systems and our catalyzed wire mesh
filter are currently our primary products and technologies.  Failure
of any of our products or technologies to achieve market acceptance may limit
our growth potential.  Further, our gross profit may vary widely in
relation to the mix of products and technologies that we sell during any
reporting period.  We may have to cease operations if all of our
primary products fail to achieve market acceptance or fail to generate
significant revenue.  Additionally, the marketability of our products
may be dependent upon obtaining verifications from regulatory agencies such as
the EPA, California Air Resources Board, or similar European agencies, as well
as the effectiveness of our products in relation to various environmental
regulations in the many jurisdictions in which we market and sell our
products.
 
 We
may not be able to successfully market new products that are developed or obtain
direct or indirect verification or approval of our new products.
 
 We plan
to market other emissions reduction devices used in combination with the
Platinum Plus fuel-borne catalyst, ARIS injector, EGR-SCR, catalyzed wire mesh
filter and diesel particulate filter regeneration.  There are numerous
development and verification issues that may preclude the introduction of these
products for commercial sale.  If we are unable to demonstrate the
feasibility of these products or obtain verification or approval for the
products from regulatory agencies, we may have to abandon the products or alter
our business plan.  Such modifications to our business plan will
likely delay achievement of revenue milestones and
profitability.
  16
 Table of Contents
  Risks
Related to Our Financial Condition
 
 We
have incurred losses in the past and expect to incur losses in the
future.
 
 We have
incurred losses since inception totaling $58.9 million as of December 31, 2008,
which amount includes approximately $4.8 million of non-cash preferred stock
dividends.  At the date of this Annual Report on Form 10-K, our cash
and cash equivalents and investments are estimated to be sufficient for our
needs through mid-2010.
 
 We have
recognized limited revenues through December 31, 2008 and expect to continue to
incur operating losses at least through 2009.  There can be no
assurance that we will achieve or sustain significant revenues, positive cash
flows from operations or profitability in the future.  See the
discussion below under the caption “Liquidity and Capital Resources” in Item 7,
“Management’s Discussion and Analysis of Financial Condition and Results of
Operations.”
 
 We
have no assurances of additional funding.
 
 We may
seek additional funding in the form of a private or public offering of equity
securities.  Debt financing would be difficult to obtain because of
limited assets and cash flows as well as current general economic
conditions.  Any equity funding may depend on prior stockholder
approval of an amendment to our certificate of incorporation authorizing
additional capital.  Any offering of shares of our common stock may
result in dilution to our existing stockholders.  Our ability to
consummate financing will depend on the status of our marketing programs and
commercialization progress, as well as conditions then prevailing in the
relevant capital markets.  There can be no assurance that such funding
will be available if needed, or on acceptable terms.  In the event
that we need additional funds and are unable to raise such funds, we may be
required to delay, reduce or severely curtail our operations or otherwise impede
our on-going commercialization, which could have a material adverse effect on
our business, operating results, financial condition and long-term
prospects.  See the discussion below under the caption “Liquidity and
Capital Resources” in Item 7, “Management’s Discussion and Analysis of Financial
Condition and Results of Operations.”
 
 If
third parties claim that our products infringe upon their intellectual property
rights, we may be forced to expend significant financial resources and
management time litigating such claims and our operating results could
suffer.
 
 Third
parties may claim that our products and systems infringe upon third-party
patents and other intellectual property rights.  Identifying
third-party patent rights can be particularly difficult, especially since patent
applications are not published until up to 18 months after their filing
dates.  If a competitor were to challenge our patents, or assert that
our products or processes infringe its patent or other intellectual property
rights, we could incur substantial litigation costs, be forced to make expensive
product modifications, pay substantial damages or even be forced to cease some
operations.  Third-party infringement claims, regardless of their
outcome, would not only drain financial resources but also divert the time and
effort of management and could result in customers or potential customers
deferring or limiting their purchase or use of the affected products or services
until resolution of the litigation.
 
 We
have been dependent on a few major customers for a significant portion of our
revenue and our revenue could decline if we are unable to maintain or develop
relationships with current or potential customers.
 
 Historically,
we have derived a significant portion of our revenue from a limited number of
customers.  For the year ended December 31, 2008, one customer
accounted for approximately 15% of our revenue.  For the year ended
December 31, 2007, three customers accounted for approximately 70% of our
revenue and for the year ended December 31, 2006, two customers accounted for
approximately 42% of our revenue.  We intend to establish long-term
relationships with existing customers and continue to expand our customer
base.  While we diligently seek to become less dependent on any single
customer, it is likely that certain contractual relationships may result in one
or more customers contributing to a significant portion of our revenue in any
given year for the foreseeable future.  The loss of one or more of our
significant customers may result in a material adverse effect on our revenue,
our ability to become profitable or our ability to continue our business
operations.
  17
 Table of Contents
  Foreign
currency fluctuations could impact financial performance.
 
 We have
increased our activities in the U.K., Europe and Asia, and consequently, are
exposed to fluctuations in foreign currency rates.  We may manage the
risk to such exposure by entering into foreign currency futures and option
contracts.  Foreign currency fluctuations may have a significant
effect on our operations in the future.
 
 An
inability to realize proceeds from our auction rate securities right issued by
UBS may significantly impact our liquidity.
 
 On November 6, 2008, the Company
accepted from UBS an Offer to acquire a “put” right to sell to UBS commencing
June 30, 2010 the Company's holdings of $11.7 million par value in auction rate
securities (ARS).  Also, UBS has established a loan facility whereby
the Company may borrow up to 75% of the UBS-determined value of these ARS
collateralized by the securities.   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 ARS upon exercise of the put
right.
 
 We
have not and do not intend to pay dividends on shares of our common
stock.
 
 We have
not paid dividends on our common stock since inception, and do not intend to pay
any dividends to our stockholders in the foreseeable future.  We
intend to reinvest earnings, if any, in the development and expansion of our
business.
 
 The
price of our common stock may be adversely affected by the sale of a significant
number of new common shares.
 
 The sale,
or availability for sale, of substantial amounts of our common stock, including
shares issued upon exercise of outstanding options and warrants or shares of
common stock that may be issued in the public market or a private placement to
fund our operations or the perception by the market that these sales could
occur, could adversely affect the market price of our common stock and could
impair our ability to raise additional working capital through the sale of
equity securities.  The perceived risk of dilution may cause existing
stockholders to sell their shares of stock, which would contribute to a decrease
in the stock price.  In that regard, downward pressure on the trading
price of our common stock may also cause investors to engage in short sales,
which would further contribute to downward pressure on the trading price of our
stock.
 
 Our
common stock is currently listed on The NASDAQ Capital Market and the
Alternative Investment Market of the London Stock Exchange.  Our
common stock trades on these exchanges in the U.S. and the U.K. and in Germany
on various regional stock exchanges and the national electronic exchange
(Xetra), and an investor’s ability to trade the stock may be limited by trading
volume and price volatility.
 
 The
trading volume in our common stock has been relatively limited and a
consistently active trading market for our common stock may not
develop.  Our common stock began trading on The NASDAQ Capital Market
effective October 3, 2007.  Prior to this date, our common stock was
traded on the OTC Bulletin Board.  The average daily trading volume in
our common stock on these exchanges in 2008 was approximately 7,915
shares.
 
 There has
been significant volatility in the market prices of publicly traded shares of
emerging growth technology companies, including our shares.  Factors
such as announcements of technical developments, verifications, establishment of
distribution agreements, significant sales orders, changes in governmental
regulation and developments in patent or proprietary rights may have a
significant effect on the market price of our common stock.  As
outlined above, there has been a low average daily trading volume of our common
stock.  To the extent this trading pattern continues, the price of our
common stock may fluctuate significantly as a result of relatively minor changes
in demand for our shares and sales of our stock by holders.
  18
 Table of Contents
  Item1B.
              Unresolved
      Staff Comments
 
 None.
 
 Item2.
              Properties
 
 We have a
five-year lease which expires on March 31, 2009 for 3,925 square feet of
administrative office space in Stamford, Connecticut.  The annual cost
of the lease including rent, utilities and parking is approximately
$128,000.  We entered into a seven-year lease expiring December 2015
for our relocated U.S. headquarters to 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.
 
 Item3.
              Legal
      Proceedings
 
 We are
not involved in any legal proceedings.
 
 Item 4.
              Submission
      of Matters to a Vote of Security
Holders
 
 No
matters were submitted to a vote of our security holders in the fourth quarter
of 2008.
 
 
 Part
II
 
 Item5.
              Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities
 
 Market
Information
 
 Our
common stock is listed on The NASDAQ Capital Market in the U.S. effective
October 3, 2007, and prior to that date, it traded on the Over-The-Counter
Bulletin Board.  Our common stock is also listed on the London Stock
Exchange through the Alternative Investment Market (AIM) and also trades in
Germany on various regional stock exchanges, including Frankfurt, as well as on
the national electronic exchange Xetra.  Reports of transactions of
our shares are available on The NASDAQ Capital Market under the trading symbol
“CDTI”, on the AIM under the symbol “CDT” and on the Frankfurt exchange under
the symbol “CDI”.
 
 The
following table sets forth the high and low bid prices of our common stock on
the U.S. Over-The-Counter Bulletin Board (OTCBB) or the high and low sale prices
of our common stock on The NASDAQ Capital Market and AIM for each of the periods
listed.  Prices indicated below with respect to our share price
include inter-dealer prices, without retail mark up, mark down or commission and
may not necessarily represent actual transactions.
 
 OTC
      Bulletin Board or
                                      
                                      
                                      AIM
      of theNASDAQ
      Capital Market
                                      
                                      
                                      London
      Stock ExchangeHigh
                                      
                                      
                                      Low
                                      
                                      
                                      High
                                      
                                      
                                      Low(In
      U.S. $)
                                      
                                      
                                      (In
      GBP)20071st
      Quarter
                                      
                                      $
                                      12.25
                                      
                                      
                                      $
                                      9.00
                                      
                                      
                                      £
                                      6.00
                                      
                                      
                                      £
                                      4.252nd
      Quarter
                                      
                                      $
                                      17.00
                                      
                                      
                                      $
                                      10.25
                                      
                                      
                                      £
                                      7.75
                                      
                                      
                                      £
                                      4.653rd
      Quarter
                                      
                                      $
                                      15.00
                                      
                                      
                                      $
                                      11.00
                                      
                                      
                                      £
                                      8.00
                                      
                                      
                                      £
                                      5.504th
      Quarter
                                      
                                      $
                                      30.00
                                      
                                      
                                      $
                                      12.50
                                      
                                      
                                      £
                                      13.24
                                      
                                      
                                      £
                                      6.1020081st
      Quarter
                                      
                                      $
                                      24.85
                                      
                                      
                                      $
                                      8.74
                                      
                                      
                                      £
                                      11.50
                                      
                                      
                                      £
                                      5.002nd
      Quarter
                                      
                                      $
                                      15.98
                                      
                                      
                                      $
                                      10.50
                                      
                                      
                                      £
                                      7.05
                                      
                                      
                                      £
                                      5.003rd
      Quarter
                                      
                                      $
                                      12.25
                                      
                                      
                                      $
                                      3.00
                                      
                                      
                                      £
                                      6.23
                                      
                                      
                                      £
                                      2.984th
      Quarter
                                      
                                      $
                                      4.79
                                      
                                      
                                      $
                                      1.54
                                      
                                      
                                      £
                                      3.00
                                      
                                      
                                      £
                                      1.10
  19
 Table of Contents
  Holders
 
 At
February 18, 2009, there were 240 holders of record of our common stock
representing approximately 1,600 beneficial owners.
 
 Dividends
 
 No
dividends have been paid on our common stock and we do not anticipate paying
cash dividends in the foreseeable future.
 
 Sales
and Uses of Unregistered Securities During the Period
 
 None.
 
 Equity
Compensation Plan Information as of December 31, 2008
 
 The
following table represents options and warrants outstanding as of December 31,
2008:
 
 Plan
      Category
                
                NumberofSharestobe
                  IssuedUponExerciseof
                  Outstanding Options, Warrants and
      Rights
                
                
                Weighted Average
                  Exercise Price of
                  OutstandingOptions, Warrants and
Rights
                
                
                Number of Shares Remaining Available for Future
      IssuanceOptions:Equity
      compensation plans approved by security holders
                
                
                972,5781
                
                
                $
                10.19
                
                
                
                451,6251Equity
      compensation plans not approved by security holders
                
                
                —
                
                
                
                —
                
                
                
                —Total
      Options
                
                
                972,578
                
                
                $
                10.19
                
                
                
                451,625Warrants:Equity
      compensation plans approved by shareholders
                
                
                —
                
                
                
                —
                
                
                
                —Equity
      compensation plans not approved by shareholders
                
                
                424,992
                
                
                $
                11.35
                
                
                
                —Total
      Warrants
                
                
                424,992
                
                
                $
                11.35
                
                
                
                —
 
 1
                Represents
      awards issued under the Incentive Plan.  The maximum number
      of awards allowed under the Incentive Plan is 17.5% of our issued and
      outstanding common stock less the outstanding options, and is subject to a
      sufficient number of shares of authorized
  capital.
  20
 Table of Contents
  Stock
Price Performance Graph
 
 The graph
below compares the cumulative total return to stockholders on the common stock
of the Company, the Russell 2000 Index and the NASDAQ Composite Index since
December 31, 2003, assuming a $100 investment.  The stock price
performance shown on the graph below is not necessarily indicative of future
price performance.
 
 
 
 
 12/31/03
                  
                  
                  12/31/04
                  
                  
                  12/31/05
                  
                  
                  12/31/06
                  
                  
                  12/31/07
                  
                  
                  12/31/08Clean Diesel Technologies,
    Inc.
                  
                  $
                  100
                  
                  
                  $
                  60
                  
                  
                  $
                  35
                  
                  
                  $
                  63
                  
                  
                  $
                  161
                  
                  
                  $
                  18Russell 2000 Index
                  
                  
                  100
                  
                  
                  
                  117
                  
                  
                  
                  121
                  
                  
                  
                  141
                  
                  
                  
                  138
                  
                  
                  
                  90NASDAQ Composite Index
                  
                  
                  100
                  
                  
                  
                  109
                  
                  
                  
                  111
                  
                  
                  
                  122
                  
                  
                  
                  132
                  
                  
                  
                  64
  21
 Table of Contents
  Item6.
              Selected
      Financial Data
 
 The
following selected financial data has been derived from our audited consolidated
financial statements.  The Statements of Operations Data relating to
2008, 2007 and 2006, and the Balance Sheet Data as of December 31, 2008 and 2007
should be read in conjunction with the audited consolidated financial
statements, including the notes thereto in Item 8, “Consolidated Financial
Statements and Supplementary Data” and Item 7, “Management’s Discussion and
Analysis of Financial Condition and Results of
Operations.”  Historical results for any prior period are not
necessarily indicative of future results for any period.
 
 For the years ended December
      31,2008
                                        
                                        
                                        2007
                                        
                                        
                                        2006
                                        
                                        
                                        2005
                                        
                                        
                                        2004(in
      thousands, except per share amounts)STATEMENTS
      OF OPERATIONS DATARevenue:Product
      sales
                                        
                                        $
                                        7,024
                                        
                                        
                                        $
                                        1,466
                                        
                                        
                                        $
                                        860
                                        
                                        
                                        $
                                        760
                                        
                                        
                                        $
                                        659License
      and royalty revenue
                                        
                                        
                                        451
                                        
                                        
                                        
                                        3,459
                                        
                                        
                                        
                                        74
                                        
                                        
                                        
                                        47
                                        
                                        
                                        
                                        54Consulting
      and other
                                        
                                        ─
                                        
                                        
                                        ─
                                        
                                        
                                        
                                        189
                                        
                                        
                                        
                                        5
                                        
                                        
                                        
                                        9Total
      revenue
                                        
                                        
                                        7,475
                                        
                                        
                                        
                                        4,925
                                        
                                        
                                        
                                        1,123
                                        
                                        
                                        
                                        812
                                        
                                        
                                        
                                        722Operating
      costs and expenses:Cost
      of total revenue
                                        
                                        
                                        5,717
                                        
                                        
                                        
                                        1,126
                                        
                                        
                                        
                                        658
                                        
                                        
                                        
                                        471
                                        
                                        
                                        
                                        455Selling,
      general and administrative
                                        
                                        
                                        9,992
                                        
                                        
                                        
                                        8,041
                                        
                                        
                                        
                                        5,278
                                        
                                        
                                        
                                        4,963
                                        
                                        
                                        
                                        3,962Research
      and development
                                        
                                        
                                        430
                                        
                                        
                                        
                                        428
                                        
                                        
                                        
                                        510
                                        
                                        
                                        
                                        439
                                        
                                        
                                        
                                        506Patent
      amortization and other expense
                                        
                                        
                                        227
                                        
                                        
                                        
                                        364
                                        
                                        
                                        
                                        235
                                        
                                        
                                        
                                        170
                                        
                                        
                                        
                                        90Loss
      from operations
                                        
                                        
                                        (8,891
                                        )
                                        
                                        
                                        (5,034
                                        )
                                        
                                        
                                        (5,558
                                        )
                                        
                                        
                                        (5,231
                                        )
                                        
                                        
                                        (4,291
                                        )Foreign
      currency exchange (loss) gain
                                        
                                        
                                        (845
                                        )
                                        
                                        
                                        (11
                                        )
                                        
                                        
                                        104
                                        
                                        
                                        
                                        (221
                                        )
                                        
                                        
                                        101Interest
      income
                                        
                                        
                                        602
                                        
                                        
                                        
                                        509
                                        
                                        
                                        
                                        58
                                        
                                        
                                        
                                        26
                                        
                                        
                                        
                                        47Other
      income (expense), net
                                        
                                        
                                        (239
                                        )
                                        
                                        
                                        1
                                        
                                        
                                        
                                        12
                                        
                                        
                                        ─
                                        
                                        
                                        ─Net
      loss
                                        
                                        $
                                        (9,373
                                        )
                                        
                                        $
                                        (4,535
                                        )
                                        
                                        $
                                        (5,384
                                        )
                                        
                                        $
                                        (5,426
                                        )
                                        
                                        $
                                        (4,143
                                        )Basic
      and diluted loss per common share
                                        
                                        $
                                        (1.15
                                        )
                                        
                                        $
                                        (0.66
                                        )
                                        
                                        $
                                        (1.03
                                        )
                                        
                                        $
                                        (1.48
                                        )
                                        
                                        $
                                        (1.29
                                        )Basic
      and diluted weighted-averageshares
      outstanding
                                        
                                        
                                        8,138
                                        
                                        
                                        
                                        6,886
                                        
                                        
                                        
                                        5,212
                                        
                                        
                                        
                                        3,678
                                        
                                        
                                        
                                        3,214As of December 31,2008
                                        
                                        
                                        2007
                                        
                                        
                                        2006
                                        
                                        
                                        2005
                                        
                                        
                                        2004(in
      thousands)BALANCE
      SHEET DATACurrent
      assets
                                        
                                        $
                                        12,219
                                        
                                        
                                        $
                                        11,871
                                        
                                        
                                        $
                                        8,287
                                        
                                        
                                        $
                                        5,505
                                        
                                        
                                        $
                                        4,868Total
      assets
                                        
                                        
                                        18,747
                                        
                                        
                                        
                                        24,663
                                        
                                        
                                        
                                        9,018
                                        
                                        
                                        
                                        6,274
                                        
                                        
                                        
                                        5,513Current
      liabilities
                                        
                                        
                                        4,056
                                        
                                        
                                        
                                        1,663
                                        
                                        
                                        
                                        1,070
                                        
                                        
                                        
                                        496
                                        
                                        
                                        
                                        391Long-term
      liabilities
                                        
                                        ─
                                        
                                        
                                        ─
                                        
                                        
                                        ─
                                        
                                        
                                        ─
                                        
                                        
                                        ─Working
      capital
                                        
                                        
                                        8,163
                                        
                                        
                                        
                                        10,208
                                        
                                        
                                        
                                        7,217
                                        
                                        
                                        
                                        5,009
                                        
                                        
                                        
                                        4,477Stockholders’
      equity
                                        
                                        
                                        14,691
                                        
                                        
                                        
                                        23,000
                                        
                                        
                                        
                                        7,948
                                        
                                        
                                        
                                        5,778
                                        
                                        
                                        
                                        5,122
  22
 Table of Contents
  Item7.
              Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
 
 Overview
 
 We design
products and license environmentally-proven technologies and solutions for the
global emission reduction market based upon our portfolio of patents and
extensive library of performance data and know-how.  We believe our
core competence is the innovation, application, development and marketing of
technological products and solutions to enable emission control.  Our
suite of technologies offers a broad range of market-ready solutions to reduce
emissions while saving costs through fuel economy improvement and reduction of
engine wear.
 
 We
believe that clean air, energy efficiency and sustainability continue to attract
increasing attention around the world, as does the need to develop alternative
energy sources.  Increasingly, combustion engine development is
influenced by concern over global warming caused by carbon dioxide emissions
from fossil fuels and toxic exhaust emissions.  Because carbon dioxide
results from the combustion of fossil fuels, reducing fuel consumption is often
cited as the primary way to reduce carbon dioxide emissions.  Further,
because diesel engines are 35% or more fuel-efficient than gasoline engines, the
increased use of diesel engines relative to gasoline engines is one way to
reduce overall fuel consumption, and thereby, significantly reduce carbon
dioxide emissions.  We believe the diesel engine is and will remain a
strategic and economic source of motive power.  However, diesel
engines emit higher levels of two toxic pollutants – particulate matter and
nitrogen oxides – than gasoline engines fitted with catalytic
converters.  Both of these pollutants affect human health and damage
the environment.  These factors, among others, have led to legislation
and standards that may drive demand for our products and solutions.
 
 Our
operating revenue consists of product sales, technology licensing fees and
royalties, and consulting and other (primarily, engineering and development
consulting services).  The following table sets forth the percentage
contribution of our revenue sources in relation to total revenue for the years
ended December 31, 2008, 2007 and 2006.
 
 (in
      thousands)For the years ended December
      31,2008
                              
                              
                              2007
                              
                              
                              2006Product
      sales
                              
                              $
                              7,024
                              
                              
                              
                              94.0%
                              
                              
                              $
                              1,466
                              
                              
                              
                              29.8%
                              
                              
                              $
                              860
                              
                              
                              
                              76.6%License
      and royalty revenue
                              
                              
                              451
                              
                              
                              
                              6.0%
                              
                              
                              
                              3,459
                              
                              
                              
                              70.2%
                              
                              
                              
                              74
                              
                              
                              
                              6.6%Consulting
      and other
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              189
                              
                              
                              
                              16.8%Total
                              
                              $
                              7,475
                              
                              
                              
                              100.0%
                              
                              
                              $
                              4,925
                              
                              
                              
                              100.0%
                              
                              
                              $
                              1,123
                              
                              
                              
                              100.0%
 
 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 include our patented Platinum Plus® fuel-borne catalyst products and
concentrate and hardware (primarily, our patented ARIS® advanced reagent
injector and dosing systems for selective catalytic reduction of nitrogen
oxides, our Platinum Plus Purifier Systems and catalyzed wire mesh
filters).  Our Platinum Plus fuel-borne catalyst is registered with
the U.S. Environmental Protection Agency (EPA) and other environmental
authorities around the world.  Our products are sold to distributors,
resellers, various transportation segments, including on-road, off-road, rail
and marine, among other end users, through our distribution network and direct
sales.
 
 We
license our ARIS nitrogen oxides selective catalytic reduction (SCR) system and
the combination of exhaust gas recirculation (EGR) with SCR to others, generally
with an up-front fee for the technology and know-how and an on-going royalty per
unit.  We also sell finished ARIS-based SCR systems to potential ARIS
licensees and end users.  We are actively seeking additional licensees
for both mobile and stationary applications.  We offer rights to our
catalyzed wire mesh technology through license agreements as well as selling
finished filters for use with our Platinum Plus fuel-borne
catalyst.
 
 Since
inception, we have devoted efforts to the research and development of
technologies and products in various areas, including platinum fuel-borne
catalysts for emission reduction and fuel economy improvement and nitrogen
oxides reduction systems to control emissions from diesel
engines.  Although we believe we have made progress in commercializing
our technologies, we have experienced recurring losses from our
operations.  Our accumulated deficit amounted to approximately $58.9
million as of December 31, 2008.  The internally generated funds from
our revenue sources have not been sufficient to cover our operating
costs.  The ability of our revenue sources, especially product sales
and technology license fees and royalties, to generate significant cash for our
operations is critical to our long-term success.  We cannot predict
whether we will be successful in obtaining market acceptance of our products or
technologies or in completing our current licensing agreement
negotiations.  To the extent our internally generated funds are
inadequate, we believe that we will need to obtain additional working capital
through equity financings.  However, we can give no assurance that any
additional financing will be available to us on acceptable terms or at
all.
  23
 Table of Contents
  Critical
Accounting Policies
 
 The
preparation of our financial statements in conformity with generally accepted
accounting principles requires our management to make estimates and assumptions
that affect the amounts reported in our consolidated financial statements and
the accompanying notes to the consolidated financial
statements.  Management bases its estimates on historical experience
and on various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis of making judgments about the
carrying values of assets and liabilities that are not readily apparent from
other sources.  Actual results may differ from these estimates under
different assumptions or conditions.
 
 An
accounting policy is deemed to be critical if it requires an accounting estimate
to be made based upon assumptions about matters that are uncertain at the time
the estimate is made, and if different estimates that reasonably could have been
used, or changes in the accounting estimates that are reasonably likely to occur
periodically, could materially impact the financial
statements.  Management believes that of our significant accounting
policies (see Note 2 of Notes to Consolidated Financial Statements), the
following critical accounting policies involve a higher degree of judgment and
complexity used in the preparation of the consolidated financial
statements.
 
 Revenue
Recognition
 
 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.  Other revenue primarily consists of engineering and
development consulting services.  Revenue from technical consulting
services is generally recognized and billed as the services are
performed.
 
 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
convey 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.
  24
 Table of Contents
  Research
and Development Costs
 
 Costs
relating to the research, development and testing of our technologies and
products are charged to operations as they are incurred.  These costs
include verification programs, evaluation and testing projects, salary and
benefits, consulting fees, materials and testing gear.  Our research
and development expenses totaled approximately $430,000, $428,000 and $510,000
for the years ended December 31, 2008, 2007 and 2006, respectively.
 
 Patents
and 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.  Indirect and other
patent-related costs are expensed as incurred.  Patent amortization
expense for the years ended December 31, 2008, 2007 and 2006 was $51,000,
$41,000 and $44,000, respectively.
 
 We
evaluate the remaining useful life of our patents each reporting period to
determine whether events and circumstances warrant a revision to the remaining
period of amortization.  If the evaluation determines that the
patent’s remaining useful life has changed, the remaining carrying amount of the
patent is amortized prospectively over that revised remaining useful
life.  We also evaluate our patents for impairment whenever events or
other changes in circumstances indicate that the carrying amount may not be
recoverable.  The testing for impairment includes evaluating the
undiscounted cash flows of the asset and the remaining period of amortization or
useful life.  The factors used in evaluating the undiscounted cash
flows include current operating results, projected future operating results and
cash flows and any other material factors that may affect the continuity or the
usefulness of the asset.  If impairment exists or if we decide to
abandon a patent, the patent is written down to its fair value based upon
discounted cash flows.  At December 31, 2008 and 2007, the Company’s
patents, net were $1,027,000 and $817,000, respectively.
 
 Newly
Adopted Accounting Standards
 
 Effective
January 1, 2008, we adopted the provisions of the Financial Accounting Standards
Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”)
No. 157, “Fair Value Measurements” for assets and liabilities measured at
fair value on a recurring basis.  SFAS No. 157defines fair value,
establishes a framework for measuring fair value in generally accepted
accounting principles and expands disclosures about fair value measurements.Specifically, SFAS No.
157 sets forth a definition of fair value, and establishes a hierarchy
prioritizing the inputs to valuation techniques, giving the highest priority to
quoted prices in active markets for identical assets and liabilities and the
lowest priority to unobservable inputs.  The provisions of SFAS No. 157 are
generally required to be applied on a prospective basis, except to certain
financial instruments accounted for under SFAS No. 133, “Accounting for
Derivative Instruments and Hedging Activities,” for which the provisions of SFAS
No. 157 should be applied retrospectively.
 
 In
October 2008, the FASB issued FASB Staff Position (“FSP”) 157-3,
“Determining the Fair Value of a Financial Asset When the Market for That Asset
Is Not Active” (“FSP 157-3”).  FSP 157-3 clarified the
application of FAS 157.  FSP 157-3 demonstrated how the fair
value of a financial asset is determined when the market for that financial
asset is inactive. FSP 157-3 was effective upon issuance, including prior
periods for which financial statements had not been issued.  The
guidance provided by FSP 157-3 is consistent with our approach to valuing our
auction rate securities for which there is no active market.
 
 In the
first quarter of 2008, we adopted SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities - Including an amendment of FASB
Statement No. 115.”  SFAS No. 159 permits an entity to elect fair
value as the initial and subsequent measurement attribute for many financial
assets and liabilities.  Entities electing the fair value option would
be required to recognize changes in fair value in earnings.  Entities
electing the fair value option are required to distinguish, on the face of the
statement of financial position, the fair value of assets and liabilities for
which the fair value option has been elected and similar assets and liabilities
measured using another measurement attribute.  The adjustment to
reflect the difference between the fair value and the carrying amount would be
accounted for as a cumulative-effect adjustment to retained earnings as of the
date of initial adoption.  SFAS No. 159 did not have a material impact
on the on the Company’s consolidated financial position, results of operations
or cash flows as the Company did not have any such financial assets and
liabilities as of January 1, 2008.
  25
 Table of Contents
  Recent
Accounting Pronouncements (not yet adopted)
 
 In
December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business
Combinations” (“SFAS No. 141R”).  SFAS No. 141R 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.  SFAS No. 141R also
expands required disclosures surrounding the nature and financial effects of
business combinations.  SFAS No. 141R will be applied
prospectively for acquisitions beginning in 2009 or thereafter.
 
 In
December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in
Consolidated Financial Statements.”  SFAS No. 160 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.  The Company does not expect the adoption of
SFAS No. 160 will have a material effect on the Company financial
position, results of operations or cash flows.
 
 In
February 2008, the FASB issued Staff Position 157-2 (“FSP
157-2”).  FSP 157-2 permits delayed adoption of SFAS 157 for 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 by FSP 157-2, the Company has
elected to delay the adoption of SFAS 157 for qualifying non-financial assets
and liabilities, such as fixed assets and patents.  The Company does
not expect the adoption of FSP 157-2 to have a material impact on the on the
Company’s consolidated financial position, results of operations or cash
flows.
 
 In March
2008, the FASB issued SFAS No. 161, "Disclosures about Derivative Instruments
and Hedging Activities" ("SFAS 161").  SFAS 161 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 under FASB Statement No. 133 and
its related interpretations and (c) how derivative instruments and related
hedged items affect a company’s financial position, results of operations and
cash flows.  The Company does not expect the adoption of
SFAS No. 161 will have a material impact on the Company’s financial
position, results of operations or cash flows.
 
 In April
2008, the FASB issued FSP FAS No. 142-3, “Determination of the Useful
Life of Intangible Assets”(“FSP
FAS No. 142-3”).  FSP FAS No. 142-3 amends the factors
that should be considered in developing renewal or extension assumptions used to
determine the useful life of a recognized intangible asset under
SFAS No. 142, Goodwill and Other Intangible Assets.  The intent
of this FSP 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 under SFAS No. 141 (revised 2007),
Business Combinations, and other US generally accepted accounting
principles.  FSP FAS No. 142-3 is effective for the Company for
fiscal years beginning after December 15, 2008.  The Company does not
expect this standard to have any material impact on the Company’s financial
position, results of operations or cash flows.
 
 In April
2008, the FASB issued EITF 07-05, “Determining Whether an Instrument (or
Embedded Feature) Is Indexed to an Entity’s Own Stock” (“EITF
07-05”).  EITF 07-05 provides 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 paragraph 11(a) of SFAS No.
133.  EITF 07-05 is effective for financial statements issued for
fiscal years beginning after December 15, 2008 and early application is not
permitted.  The Company does not expect the adoption of EITF 07-05 to
have a material impact on the Company’s financial position, results of
operations or cash flows.
  26
 Table of Contents
  Results
of Operations
 
 Year
Ended December 31, 2008 Compared to Year Ended December 31, 2007
 
 Revenue
was $7,475,000 in 2008 compared to $4,925,000 in 2007, an increase of
$2,550,000, or 51.8%, due primarily to sales of our Purifier Systems as an
emission reduction solution that meets the standards established for the London
Low Emission Zone.  Of our 2008 operating revenue, 94.0% was from
product sales and 6.0% was from technology licensing fees and
royalties.  Of our operating revenue for the year ended December 31,
2007, approximately 29.8% was from product sales and 70.2% 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 increased $5,558,000, or 379.1%, to $7,024,000 in 2008 from $1,466,000 in
2007.  The increase in product sales is attributable primarily to
demand for our Platinum Plus Purifier Systems, a product comprised of a diesel
particulate filter along with our Platinum Plus fuel-borne catalyst to enable
regeneration.  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 are being 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 deadline is October 2010 for large
vans and minibuses, followed by further compliance deadlines in
2012.  We believe sales of our Purifier Systems for compliance with
the requirements of the London Low Emission Zone may 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 model as additional Low Emission
Zones are established throughout Europe.
 
 Our
technology license fees and royalties were $451,000 in 2008 compared to
$3,459,000 in 2007, a decrease of $3,008,000, or 87.0%, with the decrease
attributable to recognition of significant up-front license fees in
2007.  In 2008 and 2007, we executed new technology licensing
agreements and recognized revenue from license fees 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 license agreements executed in 2008 include Headway
Machinery Co., Ltd. (Zhucheng City, China), Hilite International, Inc.
(Cleveland, Ohio) and Eaton Corporation.  The new license agreements
executed in 2007 included Robert Bosch GmbH and Tenneco Automotive Operating
Company Inc. and amendment of license agreement with Combustion Components
Associates, Inc.  We are continuing our efforts to consummate
technology license agreements with manufacturers and component suppliers for the
use of our technologies.
 
 Total
cost of revenue was $5,717,000 for the year ended December 31, 2008 compared to
$1,126,000 for the year ended December 31, 2007, an increase of $4,591,000, or
407.7%, due to higher costs and higher product sales volume in 2008 compared to
2007.  Total gross profit as a percentage of revenue was 23.5% and
77.1% for the years ended December 31, 2008 and 2007, respectively, with the
decrease attributable to the mix that included higher product
sales.  The gross margin for products compliant with the LEZ
requirements was initially set at a low level, based on low prices for our
products, to attract interest in our offering to establish greater visibility of
the Company in the marketplace.  Our international operation
implemented price increases late in the third quarter of 2008.  Gross
margin for product sales in 2008 was $1,307,000, or 18.6% of product sales,
compared to $340,000 in 2007, or 23.2% in 2007.  Our cost of license
fee and royalty revenue was zero in 2008 and 2007 resulting in $451,000 and
$3,459,000 gross margin, respectively.
 
 Our cost
of product sales includes the costs we incur to formulate our finished products
into salable 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.  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 consulting and other revenue includes
incremental out of pocket costs to provide consulting services.  Cost
of licensing fees and royalties is zero as there are no incremental costs
associated with the revenue.
  27
 Table of Contents
  Selling, general and administrative
expenses were $9,992,000 for the year ended December 31, 2008 compared to
$8,041,000 in 2007, an increase of $1,951,000, or 24.3%.  The increase
in selling, general and administrative costs is primarily attributable to higher
compensation and benefit costs, as well as higher professional fees, occupancy
costs and bad debt provision, as discussed further below.  Selling,
general and administrative expenses are summarized below:
 
 (in
      thousands)Years ended December 31,2008
                    
                    
                    2007Non-cash
      stock-based compensation
                    
                    $
                    1,204
                    
                    
                    $
                    1,966Compensation
      and benefits
                    
                    
                    4,386
                    
                    
                    
                    2,997Total
      compensation and benefits
                    
                    $
                    5,590
                    
                    
                    $
                    4,963Professional
      services
                    
                    
                    1,683
                    *
                    
                    
                    1,487
                    *Travel
                    
                    
                    712
                    
                    
                    
                    622Occupancy,
      property and business taxes, supplies, postage and
delivery
                    
                    
                    859
                    
                    
                    
                    511Sales
      and marketing expenses
                    
                    
                    400
                    
                    
                    
                    341Bad
      debt expense
                    
                    
                    629
                    
                    
                    
                    28Depreciation
      and all other
                    
                    
                    119
                    
                    
                    
                    89Total
                    
                    $
                    9,992
                    
                    
                    $
                    8,041
 
 *  Professional
services 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 2008 were $1,444,000, of which $1,431,000 has been included in
selling, general and administrative expenses ($1,204,000 in compensation and
$227,000 in professional services) and $13,000 in research and development
expenses.  This compares to $2,208,000 in total non-cash stock-based
compensation expense in 2007.  Effectively, the 2007 charge reflects
two grants of stock options to employees, one grant by the Board of Directors in
December 2007 and another in January 2007.
 
 Excluding
the non-cash stock-based charges, compensation and benefit expenses were
$4,386,000 for 2008 compared to $2,997,000 in 2007, an increase of $1,389,000,
or 46.3%, due to new personnel, recruitment and relocation costs, and higher
salary rates in 2008 compared to 2007.  The 2008 compensation includes
approximately $310,000 in bonuses, whereas, the 2007 compensation includes
approximately $400,000 bonus expense based upon achievement of
milestones.
 
 Professional
fees include investor relations and financial advisory fees along with
audit-related costs, including costs of complying with the requirements of
Sarbanes-Oxley.  Included in each of 2008 and 2007 is a $227,000
non-cash compensation expense for stock warrants issued for financial advisory
services.  The 2008 investor relations program costs were higher than
2007.  Occupancy costs include office rents, insurance, telephone and
communications, office supplies and related costs, along with property and
various other taxes.  We moved our U.K. administrative offices in
November 2007 and our U.S. headquarters in January 2009.  The lease
for the new U.S. office provides for more square feet at a lower per square foot
cost resulting in total rent expense at a slightly higher rate than 2008 but
with lower cash outlay in the early years of the new lease.  Bad debt
provision as a percentage of product sales for the year ended December 31, 2008
and 2007 was 9.0% and 1.9%, respectively.  The 2008 provision is
attributable to specific aged accounts.
 
 Research
and development expenses were $430,000 for the year ended December 31, 2008
compared to $428,000 in 2007, a decrease of $2,000, or 0.5%.  The
research and development expenses include $13,000 and $14,000, respectively, in
2008 and 2007 of non-cash charges for the fair value of stock options granted in
accordance with SFAS No. 123R.  The 2008 projects included laboratory
testing on additive formulations, fuel economy and carbon reduction along with
field testing of emission control technologies.  Our 2007 research and
development projects included testing required to meet Transport for London’s
certification standards for the London Low Emission Zone.  In October
2007, we received approval from Transport for London to supply our Purifier
System as an emission reduction solution that meets the standards established
for the London LEZ.
  28
 Table of Contents
  Patent
amortization and other patent costs decreased to $227,000 in 2008 from $364,000
in 2007, a decline of $137,000, or 37.6%, due to additional costs incurred in
2007 associated with the protection of our patents.  Included are
$38,000 and $58,000 in 2008 and 2007, respectively, related to abandonment of
some patents in jurisdictions that we deemed unnecessary.  Patent
amortization expense for the years ended December 31, 2008 and 2007 was $51,000
and $41,000, respectively.
 
 Interest
income was $602,000 for the year ended December 31, 2008 compared to $509,000 in
2007, an increase of $93,000, or 18.3%, due to higher invested balances during
the 2008 period, although at lower rates than 2007.
 
 Foreign
currency transaction losses, net of gains, were $845,000 and $11,000,
respectively for the year ended December 31, 2008 and 2007 due to the
strengthening U.S. dollar.
 
 Other
expense was $239,000 in 2008 and is comprised of interest expense ($56,000),
impairment loss on investments, net ($185,000) and miscellaneous other
income.
 
 Interest
expense was $56,000 in 2008 compared to zero in 2007 and is due to our borrowing
of all of the $3.0 million line of credit we had established with
UBS.
 
 The fair
value of our auction rate securities (“ARS”) was approximately $10.2 million
(par value of $11.7 million) and $18.8 million (par value of $18.8 million) as
of December 31, 2008 and 2007, respectively.  We sold $7.1 million of
these investments in 2008.  The fair value declined $1.5 million from
par value in 2008, which loss was charged to 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 an auction rate securities right (“ARSR”) at a fair value
of $1.3 million and recognized the gain in operations, which, together with the
$1.5 million decline in fair value of the ARS, resulted in a net charge to
operations in 2008 of $0.2 million included in other expense.  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.
 
 Year
Ended December 31, 2007 Compared to Year Ended December 31, 2006
 
 Revenue
was $4,925,000 in 2007 compared to $1,123,000 in 2006, an increase of
$3,802,000, or 338.6%, reflecting increases in all of our revenue sources,
except consulting and other.  Of our operating revenue for the year
ended December 31, 2007, approximately 29.8% was from product sales and 70.2%
was from technology licensing fees and royalties.  Of our operating
revenue for the year ended December 31, 2006, approximately 76.6% was from
product sales, 6.6% was from technology licensing fees and royalties and 16.8%
was from consulting and other revenue.  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.
 
 In 2007,
we made progress in our ongoing initiative to consummate technology license
agreements with manufacturers and component suppliers, including execution of
new and amended technology licensing agreements 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 technology license fees and royalties were
$3,459,000 in 2007 compared to $74,000 in 2006 and were primarily attributable
to upfront license fees from new and amended licenses.
 
 Product
sales increased $606,000, or 70.5%, to $1,466,000 in 2007 from $860,000 in
2006.  The increase in product sales is attributable primarily to
higher demand for our Platinum Plus Purifier Systems, a bundled product
comprised of a diesel particulate filter along with our Platinum Plus fuel-borne
catalyst to enable regeneration.  In October 2007, we received
approval from Transport for London to supply our Purifier System as an emission
reduction solution that meets the standards established for the London Low
Emission Zone.
  29
 Table of Contents
  Total
cost of revenue was $1,126,000 for the year ended December 31, 2007 compared to
$658,000 for the year ended December 31, 2006, an increase of $468,000, or
71.1%, due to higher costs and higher product sales volume in 2007 compared to
2006.  Total gross profit as a percentage of revenue was 77.1% and
41.4% for the years ended December 31, 2007 and 2006, respectively, with the
increase attributable to the mix that included higher technology license fees
and royalty revenue.  Gross margin for product sales in 2007 was
$340,000, or 23.2% of product sales, compared to $248,000 in 2006, or
28.8%.  Our cost of license fee and royalty revenue was zero in 2007
resulting in $3,459,000 gross margin.
 
 Our cost
of revenue – product sales includes the costs we incur to formulate our finished
products into salable 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 – consulting and other includes
incremental out of pocket costs to provide consulting services.  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 $8,041,000 for the year ended December
31, 2007 compared to $5,278,000 in 2006, an increase of $2,763,000, or
52.3%.  The increase in selling, general and administrative costs is
primarily attributable to higher non-cash charges for the fair value of stock
options and warrants as discussed further below.  Selling, general and
administrative expenses are summarized below:
 
 (in
      thousands)Years ended December 31,2007
                    
                    
                    2006Non-cash
      stock-based compensation
                    
                    $
                    1,966
                    
                    
                    $
                    304Severance
                    
                    
                    
                    
                    
                    357Compensation
      and benefits
                    
                    
                    2,997
                    
                    
                    
                    2,400Total
      compensation and benefits
                    
                    $
                    4,963
                    
                    
                    $
                    3,061Professional
      services
                    
                    
                    1,487
                    *
                    
                    
                    792Travel
                    
                    
                    622
                    
                    
                    
                    538Occupancy
                    
                    
                    511
                    
                    
                    
                    406Sales
      and marketing expenses
                    
                    
                    341
                    
                    
                    
                    279Bad
      debts
                    
                    
                    28
                    
                    
                    
                    33Depreciation
      and all other
                    
                    
                    89
                    
                    
                    
                    169Total
                    
                    $
                    8,041
                    
                    
                    $
                    5,278
 
 *  Includes
$227,000 of non-cash stock-based compensation charges for fair value of
warrants.
 
 Compensation
and benefit expense for the year ended December 31, 2007 includes $1,966,000 of
non-cash charges for the fair value of stock options granted in accordance with
SFAS No. 123R, which we adopted in January 2006 compared to $304,000 of non-cash
charges for the fair value of stock options in 2006.  Historically,
the Board of Directors has granted employee stock options in December each year
but did not grant stock options in December 2006 because of financing activities
then underway and determined to make those grants in January
2007.  Effectively, the 2007 charge reflects two grants of stock
options to employees, one grant by the Board of Directors in December 2007 and
another in January 2007 (the grant that would typically have been made in
December with respect to the 2006 year).
 
 Professional
fees include public relations, investor relations and financial advisory fees
along with audit-related costs.  Included in 2007 is a $227,000
non-cash compensation expense for stock warrants issued for financial advisory
services.  The significant component of the increase in professional
fees is attributable to the high costs of complying with the requirements of
Sarbanes-Oxley.  Occupancy costs include office rents, insurance and
related costs.  We moved our U.K. administrative offices in November
2007 and expect higher occupancy costs in the future.  We increased
our investment in sales and marketing in 2007 with the objective of laying the
groundwork for sales growth and licensing of our core technologies in
2008.
  30
 Table of Contents
  Research
and development expenses were $428,000 for the year ended December 31, 2007
compared to $510,000 in 2006, a decrease of $82,000, or 16.1%, due to fewer
verification projects and test programs conducted in 2007.  The 2007
research and development expenses include $14,000 of non-cash charges for the
fair value of stock options granted in accordance with SFAS No. 123R compared to
zero in 2006.  Our 2007 research and development projects included
testing required to meet Transport for London’s certification standards for the
London Low Emission Zone.  In October 2007, we received approval from
Transport for London to supply our Purifier System as an emission reduction
solution that meets the standards established for the London LEZ.
 
 Patent
amortization and other patent costs increased to $364,000 in 2007 from $235,000
in 2006.  Included are $58,000 and $17,000 in 2007 and 2006,
respectively, related to abandonment of some patents in jurisdictions that we
deemed unnecessary.  Patent amortization expense for the years ended
December 31, 2007 and 2006 was $41,000 and $44,000, respectively.
 
 Interest
income was $509,000 for the year ended December 31, 2007 compared to $58,000 in
2006, an increase of $451,000 due to the higher average balance of invested
funds in 2007 from the December 2006 private placement funding and exercise of
warrants issued in that placement as further outlined in the section entitled
“Liquidity and Capital Resources” below.
 
 Liquidity and Capital
Resources
 
 Net cash
used for operating activities was $6.8 million for the year ended December 31,
2008 and was used primarily to fund the 2008 net loss of $9.4 million, adjusted
for non-cash items.  Included in the 2008 non-cash items was
share-based compensation expense of $1.4 million accounted for in accordance
with SFAS No. 123R.
 
 Accounts
receivable, net decreased to $637,000 at December 31, 2008 from $1,927,000 at
December 31, 2007 primarily due to collection of receivables from sales of our
Purifier System to meet the requirements of the London Low Emission Zone
(February and July 2008 were LEZ compliance deadlines in 2008).  In
addition, accounts receivable, net declined due to an increase in the allowance
for doubtful accounts due to more aged accounts caused by slower collections
attributable to a difficult economic environment.  Inventories, net
decreased to $974,000 at December 31, 2008 from $1,093,000 at December 31, 2007
due to the timing of our platinum metal purchases.  Our accounts
payable and accrued expenses decreased $572,000 reflecting slower general
business activities at the end of 2008 compared to the end of 2007 when the
Company was involved in launching its accredited Platinum Plus Purifier Systems
in response to demand for retrofit systems to comply with the London
LEZ.
 
 Investing
activities provided $6.6 million in 2008, primarily from sales of auction rate
securities.  We capitalized $212,000 of fixed assets primarily
associated with our U.S. headquarters to which we relocated in January
2009.  We used $299,000 for investments in our patents, including
patent applications in foreign jurisdictions.  We expect to continue
to invest in our patents.
 
 Cash
provided by financing activities was $3.0 million for the year ended December
31, 2008 and is attributable primarily to proceeds from borrowing from a demand
loan facility.  We are using the proceeds from short-term debt for
general working capital purposes.
 
 At
December 31, 2008 and 2007, we had cash and cash equivalents of $4.0 million and
$1.5 million, respectively, an increase of $2.5 million.  Our working
capital was $8.2 million at December 31, 2008 compared to $10.2 million at
December 31, 2007, a decrease of $2.0 million primarily attributable to the $1.3
million decrease in accounts receivable, net.
 
 At
December 31, 2008, our investments are recorded at fair value in accordance with
SFAS No. 157 and comprise auction rate securities (“ARS”) and an ARS put right
(“ARSR”).  At December 31, 2008 and 2007, we held approximately $10.2
million ($11.7 million par value) and $18.8 million ($18.8 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.  We sold $7.1 million of these investments in
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.
  31
 Table of Contents
  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 (see Note 9 of Notes to Consolidated Financial
Statements).  In January 2009, UBS approved a $6.5 million credit
facility.  The ARS serve as collateral for the loan which is due upon
demand (see Note 15 of Notes to Consolidated Financial Statements).
 
 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 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.  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.
 
 At
December 31, 2007 and for the period through the date the Company accepted the
Offer, the Company classified the ARS as available-for-sale under SFAS No.
115.  Thereafter, the Company transferred the ARS to the trading
category.
 
 The fair
value of the ARS was approximately $10.2 million and $18.8 million at December
31, 2008 and 2007, respectively.  We sold $7.1 million of these
investments in 2008.  The fair value declined $1.5 million from par
value in 2008, which loss was charged to 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 the ARSR at a fair value of $1.3 million and recognized the gain in
operations, which, together with the $1.5 million decline in fair value of the
ARS, resulted in a net charge to operations in 2008 of $0.2 million included in
other expense.  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 value 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 December 31, 2008, the Company classified
$3.0 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 (a) the ability
to acquire the par value of its ARS upon exercise of the put right, or (b) that
the Company may receive significant loan proceeds from the UBS loan
facility.
 
 Our
management believes that based upon the Company’s cash and cash equivalents and
investments at December 31, 2008, 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
incurred losses since inception aggregating $58.9 million, which amount includes
$4.8 million of non-cash preferred stock dividends.  We expect to
incur losses through the foreseeable future, until our products and
technological solutions achieve greater awareness.  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.
  32
 Table of Contents
  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
December 31, 2008, we had no commitments for capital expenditures and no
material commitments are anticipated in the near future.
 
 Contractual
Obligations
 
 The
following is a summary of our contractual obligations as of December 31,
2008:
 
 (in
      thousands)2
      to 3
                    
                    
                    4
      to 5
                    
                    
                    Over
      5Total
                    
                    
                    1 Year
                    
                    
                    Years
                    
                    
                    Years
                    
                    
                    YearsOperating
      Leases
                    
                    $
                    1,215
                    
                    
                    $
                    201
                    
                    
                    $
                    361
                    
                    
                    $
                    349
                    
                    
                    $
                    304
 The
operating leases include our facilities in the U.S. and U.K. and consist of
leases with the following remaining terms:  three months of a
five-year lease for our executive offices, 84 months under a new lease for our
relocated U.S. headquarters, seven months under a one-year lease for warehouse
space and 51 months under a 64-month lease for administrative
offices.
 
 Off-Balance
Sheet Arrangements
 
 As part
of our on-going business, we do not participate in transactions that generate
relationships with unconsolidated entities or financial partnerships, which
would have been established for the purpose of facilitating off-balance sheet
arrangements or other contractually narrow or limited purposes.  As of
December 31, 2008, there were no off-balance sheet transactions.
 
 Factors
Affecting our Business and Prospects
 
 See Item
1A. “Risk Factors.”
 
 Item7A.
              Quantitative
      and Qualitative Disclosures about Market
Risk
 
 In the
opinion of management, with the exception of exposure to fluctuations in the
cost of platinum, exchange rates for pounds sterling and Euros, and current
turmoil in the capital markets, we are not subject to any significant market
risk exposure.  We monitor the price of platinum and exchange rates
and adjust our procurement strategies as needed.  See Item 1A. “Risk
Factors—Platinum Price.”  Please also see Item 1A. “Risk
Factors—Auction Rate Securities Right” for discussion of factors relating to our
investments that may impact the Company.
  33
 Table of Contents
  Item8.
              Consolidated
      Financial Statements and Supplementary
Data
 
 
 REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
 Board of
Directors and Stockholders
 Clean
Diesel Technologies, Inc.
 
 
 We have
audited the accompanying consolidated balance sheets of Clean Diesel
Technologies, Inc. and subsidiary (the "Company") as of December 31, 2008 and
2007 and the related consolidated statements of operations, comprehensive loss,
changes in stockholders' equity and cash flows for each of the years in the
three-year period ended December 31, 2008.  Our
audits also included the financial statement Schedule II - Valuation and
Qualifying Accounts for each of the years in the three-year period ended
December 31, 2008 listed in Item 15(a)(2) in the accompanying index. 
These consolidated financial statements and schedule are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these consolidated financial statements based on our
audits.
 
 We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audits to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
 
 In our
opinion, the financial statements referred to above present fairly, in all
material respects, the consolidated financial position of Clean Diesel
Technologies, Inc. and subsidiary as of December 31, 2008 and 2007 and the
consolidated results of their operations and their consolidated cash flows for
each of the years in the three-year period ended December 31, 2008 in conformity
with accounting principles generally accepted in the United States of
America.  Also, in
our opinion, the referred financial statement schedule, when considered in
relation to the basic consolidated financial statements taken as a whole,
presents fairly, in all material respects, the information stated
therein.
 
 As
described in Note 2 to the Consolidated Financial Statements, effective January
1, 2008, the Company adopted Statement of Financial Accounting Standards No.
159, “The Fair Value Option for Financial Assets and Liabilities.”
 
 We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), Clean Diesel Technologies, Inc.’s internal
control over financial reporting as of December 31, 2008, based on criteria
established in Internal Control-Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission, and our report dated March
13, 2009 expressed an unqualified opinion thereon.
 
 
 /s/  Eisner
LLP
 
 New York,
New York
 March 13,
2009
  34
 Table of Contents
  CLEAN
DIESEL TECHNOLOGIES, INC.
 Consolidated
Balance Sheets
 (in
thousands, except share data)
 
 December 31,2008
                          
                          
                          2007AssetsCurrent
      assets:Cash
      and cash equivalents
                          
                          $
                          3,976
                          
                          
                          $
                          1,517Accounts
      receivable, net of allowance of $359 and $49, respectively
                          
                          
                          637
                          
                          
                          
                          1,927Investments
                          
                          
                          6,413
                          
                          
                          
                          7,100Inventories,
      net
                          
                          
                          974
                          
                          
                          
                          1,093Other
      current assets
                          
                          
                          219
                          
                          
                          
                          234Total
      current assets
                          
                          
                          12,219
                          
                          
                          
                          11,871Investments
                          
                          
                          5,127
                          
                          
                          
                          11,725Patents,
      net
                          
                          
                          1,027
                          
                          
                          
                          817Fixed
      assets, net of accumulated depreciation of $505 and $421,
      respectively
                          
                          
                          296
                          
                          
                          
                          175Other
      assets
                          
                          
                          78
                          
                          
                          
                          75Total
      assets
                          
                          $
                          18,747
                          
                          
                          $
                          24,663Liabilities
      and Stockholders’ EquityCurrent
      liabilities:Accounts
      payable
                          
                          $
                          501
                          
                          
                          $
                          757Accrued
      expenses
                          
                          
                          534
                          
                          
                          
                          850Short-term
      debt
                          
                          
                          3,013
                          
                          
                          ─Customer
      deposits
                          
                          
                          8
                          
                          
                          
                          56Total
      current liabilities
                          
                          
                          4,056
                          
                          
                          
                          1,663Commitments
      (Note 10)Stockholders’
      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 8,138,304 and 8,124,056 shares, respectively
                          
                          
                          81
                          
                          
                          
                          81Additional
      paid-in capital
                          
                          
                          73,901
                          
                          
                          
                          72,447Accumulated
      other comprehensive loss
                          
                          
                          (406
                          )
                          
                          
                          (16
                          )Accumulated
      deficit
                          
                          
                          (58,885
                          )
                          
                          
                          (49,512
                          )Total
      stockholders’ equity
                          
                          
                          14,691
                          
                          
                          
                          23,000Total
      liabilities and stockholders’ equity
                          
                          $
                          18,747
                          
                          
                          $
                          24,663The
      accompanying notes are an integral part of the consolidated financial
      statements.
  35
 Table of Contents
  CLEAN
DIESEL TECHNOLOGIES, INC.
 Consolidated
Statements of Operations
 (in
thousands, except per share amounts)
 
 For the years ended December
      31,Revenue:
                                                    
                                                    2008
                                                    
                                                    
                                                    2007
                                                    
                                                    
                                                    2006Product
      sales
                                                    
                                                    $
                                                    7,024
                                                    
                                                    
                                                    $
                                                    1,466
                                                    
                                                    
                                                    $
                                                    860Technology
      licensing fees and royalties
                                                    
                                                    
                                                    451
                                                    
                                                    
                                                    
                                                    3,459
                                                    
                                                    
                                                    
                                                    74Consulting
      and other
                                                    
                                                    ─
                                                    
                                                    
                                                    ─
                                                    
                                                    
                                                    
                                                    189Total
      revenue
                                                    
                                                    
                                                    7,475
                                                    
                                                    
                                                    
                                                    4,925
                                                    
                                                    
                                                    
                                                    1,123Costs
      and expenses:Cost
      of product sales
                                                    
                                                    
                                                    5,717
                                                    
                                                    
                                                    
                                                    1,126
                                                    
                                                    
                                                    
                                                    612Cost
      of licensing fees and royalties
                                                    
                                                    ─
                                                    
                                                    
                                                    ─
                                                    
                                                    
                                                    ─Cost
      of consulting and other revenue
                                                    
                                                    ─
                                                    
                                                    
                                                    ─
                                                    
                                                    
                                                    
                                                    46Selling,
      general and administrative
                                                    
                                                    
                                                    9,992
                                                    
                                                    
                                                    
                                                    8,041
                                                    
                                                    
                                                    
                                                    5,278Research
      and development
                                                    
                                                    
                                                    430
                                                    
                                                    
                                                    
                                                    428
                                                    
                                                    
                                                    
                                                    510Patent
      amortization and other expense
                                                    
                                                    
                                                    227
                                                    
                                                    
                                                    
                                                    364
                                                    
                                                    
                                                    
                                                    235Operating
      costs and expenses
                                                    
                                                    
                                                    16,366
                                                    
                                                    
                                                    
                                                    9,959
                                                    
                                                    
                                                    
                                                    6,681Loss
      from operations
                                                    
                                                    
                                                    (8,891
                                                    )
                                                    
                                                    
                                                    (5,034
                                                    )
                                                    
                                                    
                                                    (5,558
                                                    )Other
      income (expense):Foreign
      currency exchange (loss) gain
                                                    
                                                    
                                                    (845
                                                    )
                                                    
                                                    
                                                    (11
                                                    )
                                                    
                                                    
                                                    104Interest
      income
                                                    
                                                    
                                                    602
                                                    
                                                    
                                                    
                                                    509
                                                    
                                                    
                                                    
                                                    58Other
                                                    
                                                    
                                                    (239
                                                    )
                                                    
                                                    
                                                    1
                                                    
                                                    
                                                    
                                                    12Net
      loss
                                                    
                                                    $
                                                    (9,373
                                                    )
                                                    
                                                    $
                                                    (4,535
                                                    )
                                                    
                                                    $
                                                    (5,384
                                                    )Basic
      and diluted loss per common share
                                                    
                                                    $
                                                    (1.15
                                                    )
                                                    
                                                    $
                                                    (0.66
                                                    )
                                                    
                                                    $
                                                    (1.03
                                                    )Basic
      and diluted weighted-average number ofcommon
      shares outstanding
                                                    
                                                    
                                                    8,138
                                                    
                                                    
                                                    
                                                    6,886
                                                    
                                                    
                                                    
                                                    5,212Consolidated
      Statements of Comprehensive Loss(in
      thousands)For the years ended December
      31,2008
                                                    
                                                    
                                                    2007
                                                    
                                                    
                                                    2006Net
      loss
                                                    
                                                    $
                                                    (9,373
                                                    )
                                                    
                                                    $
                                                    (4,535
                                                    )
                                                    
                                                    $
                                                    (5,384
                                                    )Other
      comprehensive income (loss):Foreign
      currency translation adjustment
                                                    
                                                    
                                                    (390
                                                    )
                                                    
                                                    
                                                    (20
                                                    )
                                                    
                                                    
                                                    4Comprehensive
      loss
                                                    
                                                    $
                                                    (9,763
                                                    )
                                                    
                                                    $
                                                    (4,555
                                                    )
                                                    
                                                    $
                                                    (5,380
                                                    )The
      accompanying notes are an integral part of the consolidated financial
      statements.
  36
 Table of Contents
  CLEAN
DIESEL TECHNOLOGIES, INC.
 Consolidated
Statements of Changes in Stockholders’ Equity
 (in
thousands)
  Additional
      Paid-in
      Capital
                            
                            
                            Accumulated
      Other
      Comprehensive
      Income (Loss)
                            
                            
                            Accumulated
      Deficit
                            
                            
                            Total
      Stockholders’
      EquityCommon
      StockCommon Stock
                            
                            
                            To be IssuedShares
                            
                            
                            Amount
                            
                            
                            Shares
                            
                            
                            AmountBalance
      at December 31, 2005
                            
                            
                            5,073
                            
                            
                            $
                            51
                            
                            
                            
                            141
                            
                            
                            $
                            1
                            
                            
                            $
                            45,319
                            
                            
                            $ ─
                            
                            
                            $
                            (39,593
                            )
                            
                            $
                            5,778Net
      loss
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            (5,384
                            )
                            
                            
                            (5,384
                            )Options
      exercised
                            
                            
                            3
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            14
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            14Compensation
      expense forstock
      options
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            304
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            304Issuance
      of common stock
                            
                            
                            876
                            
                            
                            
                            9
                            
                            
                            
                            (141
                            )
                            
                            
                            (1
                            )
                            
                            
                            4,718
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            4,726Common
      stock subscribed andto
      be issued
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            668
                            
                            
                            
                            7
                            
                            
                            
                            4,306
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            4,313Subscriptions
      receivable, net(unpaid
      as of March 23, 2007)
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            (1,901
                            )
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            (1,901
                            )Foreign
      currency translation
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            4
                            
                            
                            ─
                            
                            
                            
                            4Payment
      of directors’ fees incommon
      stock
                            
                            
                            12
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            94
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            94Balance
      at December 31, 2006
                            
                            
                            5,964
                            
                            
                            $
                            60
                            
                            
                            
                            668
                            
                            
                            $
                            7
                            
                            
                            $
                            52,854
                            
                            
                            $
                            4
                            
                            
                            $
                            (44,977
                            )
                            
                            $
                            7,948Net
      loss
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            (4,535
                            )
                            
                            
                            (4,535
                            )Warrants
      exercised
                            
                            
                            1,400
                            
                            
                            
                            14
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            15,159
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            15,173Options
      exercised
                            
                            
                            72
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            353
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            353Compensation
      expense forstock
      options
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            2,208
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            2,208Issuance
      of common stock
                            
                            
                            668
                            
                            
                            
                            7
                            
                            
                            
                            (668
                            )
                            
                            
                            (7
                            )
                            
                            
                            1,901
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            1,901Foreign
      currency translation
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            (20
                            )
                            
                            ─
                            
                            
                            
                            (20
                            )Expenses
      of registration andreverse
      split
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            (168
                            )
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            (168
                            )Payment
      of directors’ fees incommon
      stock
                            
                            
                            20
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            140
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            140Balance
      at December 31, 2007
                            
                            
                            8,124
                            
                            
                            $
                            81
                            
                            
                            ─
                            
                            
                            $
                            ─
                            
                            
                            $
                            72,447
                            
                            
                            $
                            (16
                            )
                            
                            $
                            (49,512
                            )
                            
                            $
                            23,000Net
      loss
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            (9,373
                            )
                            
                            
                            (9,373
                            )Options
      exercised
                            
                            
                            14
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            24
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            24Compensation
      expense forstock
      options
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            1,444
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            1,444Expenses
      of registration
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            (14
                            )
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            (14
                            )Foreign
      currency translation
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            ─
                            
                            
                            
                            (390
                            )
                            
                            ─
                            
                            
                            
                            (390
                            )Balance
      at December 31, 2008
                            
                            
                            8,138
                            
                            
                            $
                            81
                            
                            
                            ─
                            
                            
                            $
                            ─
                            
                            
                            $
                            73,901
                            
                            
                            $
                            (406
                            )
                            
                            $
                            (58,885
                            )
                            
                            $
                            14,691The
      accompanying notes are an integral part of the consolidated financial
      statements.
  37
 Table of Contents
  CLEAN
DIESEL TECHNOLOGIES, INC.
 Consolidated
Statements of Cash Flow
 (in
thousands)
 
 For the years ended December
      31,2008
                                              
                                              
                                              2007
                                              
                                              
                                              2006Operating
      activitiesNet
      loss
                                              
                                              $
                                              (9,373
                                              )
                                              
                                              $
                                              (4,535
                                              )
                                              
                                              $
                                              (5,384
                                              )Adjustments
      to reconcile net loss to cash used in operating
activities:Depreciation
      and amortization
                                              
                                              
                                              142
                                              
                                              
                                              
                                              112
                                              
                                              
                                              
                                              138Provision
      for inventory
                                              
                                              ─
                                              
                                              
                                              
                                              22
                                              
                                              
                                              
                                              27Provision
      for doubtful accounts, net
                                              
                                              
                                              629
                                              
                                              
                                              
                                              28
                                              
                                              
                                              
                                              23Compensation
      expense for stock options and warrants
                                              
                                              
                                              1,444
                                              
                                              
                                              
                                              2,208
                                              
                                              
                                              
                                              304Loss
      on disposition/abandonment of fixed assets/patents
                                              
                                              
                                              38
                                              
                                              
                                              
                                              58
                                              
                                              
                                              
                                              23Loss
      on investments, net
                                              
                                              
                                              185
                                              
                                              
                                              ─
                                              
                                              
                                              ─Changes
      in operating assets and liabilities:Accounts
      receivable
                                              
                                              
                                              661
                                              
                                              
                                              
                                              (1,855
                                              )
                                              
                                              
                                              2Inventories
                                              
                                              
                                              119
                                              
                                              
                                              
                                              (750
                                              )
                                              
                                              
                                              (107
                                              )Other
      current assets and other assets
                                              
                                              
                                              12
                                              
                                              
                                              
                                              (177
                                              )
                                              
                                              
                                              (12
                                              )Accounts
      payable and accrued expenses
                                              
                                              
                                              (572
                                              )
                                              
                                              
                                              677
                                              
                                              
                                              
                                              678Other
      liabilities
                                              
                                              
                                              (48
                                              )
                                              
                                              
                                              56
                                              
                                              
                                              
                                              (9
                                              )Net
      cash used for operating activities
                                              
                                              
                                              (6,763
                                              )
                                              
                                              
                                              (4,156
                                              )
                                              
                                              
                                              (4,317
                                              )Investing
      activitiesSale
      (purchase) of investments, net
                                              
                                              
                                              7,100
                                              
                                              
                                              
                                              (18,825
                                              )
                                              
                                              ─Patent
      costs
                                              
                                              
                                              (299
                                              )
                                              
                                              
                                              (313
                                              )
                                              
                                              
                                              (94
                                              )Purchase
      of fixed assets
                                              
                                              
                                              (212
                                              )
                                              
                                              
                                              (154
                                              )
                                              
                                              
                                              (20
                                              )Net
      cash provided by (used for) investing activities
                                              
                                              
                                              6,589
                                              
                                              
                                              
                                              (19,292
                                              )
                                              
                                              
                                              (114
                                              )Financing
      activitiesProceeds
      from short-term debt
                                              
                                              
                                              3,013
                                              
                                              
                                              ─
                                              
                                              
                                              ─Proceeds
      from issuance of common stock, net
                                              
                                              ─
                                              
                                              
                                              
                                              4,313
                                              
                                              
                                              
                                              5,214Proceeds
      from exercise of warrants
                                              
                                              ─
                                              
                                              
                                              
                                              15,173
                                              
                                              
                                              ─Proceeds
      from exercise of stock options
                                              
                                              
                                              24
                                              
                                              
                                              
                                              353
                                              
                                              
                                              
                                              14Stockholder-related
      charges
                                              
                                              
                                              (14
                                              )
                                              
                                              
                                              (168
                                              )
                                              
                                              ─Net
      cash provided by financing activities
                                              
                                              
                                              3,023
                                              
                                              
                                              
                                              19,671
                                              
                                              
                                              
                                              5,228Effect
      of exchange rate changes on cash
                                              
                                              
                                              (390
                                              )
                                              
                                              
                                              (20
                                              )
                                              
                                              
                                              4Net
      increase (decrease) in cash and cash equivalents
                                              
                                              $
                                              2,459
                                              
                                              
                                              $
                                              (3,797
                                              )
                                              
                                              $
                                              801Cash
      and cash equivalents at beginning of the year
                                              
                                              
                                              1,517
                                              
                                              
                                              
                                              5,314
                                              
                                              
                                              
                                              4,513Cash
      and cash equivalents at end of the year
                                              
                                              $
                                              3,976
                                              
                                              
                                              $
                                              1,517
                                              
                                              
                                              $
                                              5,314Supplemental
      non-cash activities:Common
      stock subscribed, net
                                              
                                              $
                                              ─
                                              
                                              
                                              $
                                              ─
                                              
                                              
                                              $
                                              4,313Payment
      of accrued directors’ fees in common stock
                                              
                                              ─
                                              
                                              
                                              
                                              140
                                              
                                              
                                              
                                              94The
      accompanying notes are an integral part of the consolidated financial
      statements.
  38
 Table of Contents
 CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
  1.         Business
and Basis of Presentation
 
 Clean
Diesel Technologies, Inc. (“CDT,” the “Company,” “we,” “us” or “our”) (a
Delaware corporation) is a developer of technological solutions to reduce
harmful emissions from internal combustion engines while improving fuel
economy.   The Company licenses its patented technologies to
leading manufacturers and suppliers, addressing original equipment (OEM) and
retrofit markets globally.  The Company’s products and patented
technologies include Platinum Plus®, a fuel-borne catalyst; a range of PurifierTM
Systems, which combines its fuel-borne catalyst in integrated emission control
aftertreatment systems with diesel particulate filters, diesel oxidation
catalysts, or with catalyzed wire mesh filter systems; and the ARIS® nitrogen
oxides selective catalytic reduction (SCR) system.   CDT is
establishing a network of licensed distributors to sell and market its selective
catalytic products and solutions.   For market development and
technology validation purposes, CDT also directly markets and sells products
based on its suite of technologies to end-users, such as corporate fleets,
generating demand, proving product performance, and creating further
innovations.  CDT’s strategy for commercialization of its
technologies, including the patented combination of exhaust gas recirculation
(EGR) with SCR and the ARIS nitrogen oxides reduction system, is to enter into
license agreements with OEMs, Tier 1 suppliers and retrofit providers for the
patents and related know-how, compensating the Company by market-appropriate
up-front license fee structures and on-going royalties.   The
success of the Company’s technologies will depend upon the commercialization
opportunities as supported by federal, state and local governmental regulations
and by incentives driving adoption around the world.
 
 During
2008, 2007 and 2006, the Company incurred net losses of approximately $9.4
million, $4.5 million and $5.4 million, respectively, and at December 31, 2008,
has an accumulated deficit of approximately $58.9 million.  Net cash
used for operating activities for the year ended December 31, 2008 was
approximately $6.8 million.  As of December 31, 2008, the Company’s
cash and cash equivalents were $4.0 million, investments were $11.5 million and
working capital was $8.2 million.  Based upon the Company’s operating
and cash plan for 2009, management believes that the Company will have
sufficient working capital to fund its operations through December 31,
2009.
 
 2.         Significant
Accounting Policies
 
 Consolidation:
 
 The
consolidated financial statements include the accounts of CDT and Clean Diesel
International, LLC (“CD International”), its wholly-owned subsidiary, after
elimination of all significant intercompany transactions and
balances.
 
 Reverse
Split of Common Stock:
 
 On June
15, 2007, the Company effected a five-for-one reverse split of its common
stock.  All historical share numbers and per share amounts in these
financial statements have been adjusted to give effect to this reverse split
(see Note 7).
 
 Use
of Estimates:
 
 The
preparation of financial statements and related disclosures in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities, the disclosure of contingent assets and
liabilities at the date of the financial statements, and revenue and expenses
during the period reported.  These estimates include assessing the
collectibility of accounts receivable, the use and realizability of inventories,
useful lives for depreciation, amortization periods of intangible assets and the
fair value of investments.  The markets for our products and services
are characterized by rapid technological development and evolving standards, all
of which could impact the future realizability of our
assets.  Estimates and assumptions are reviewed periodically and the
effects of revisions are reflected in the period that they are determined to be
necessary.  Actual results could differ from those
estimates.
  39
 Table of Contents
 CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
  Revenue
Recognition:
 
 The
Company generates revenue from product sales comprised of fuel-borne catalysts,
including the Platinum Plus fuel-borne catalyst products and concentrate and
hardware including the Purifier System, ARIS advanced reagent injection system
injectors and dosing systems; license and royalty fees from the ARIS System and
other technologies; and consulting fees and other.
 
 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.  Other revenue primarily consists of engineering and
development consulting services.  Revenue from technical consulting
services is generally recognized and billed as the services are
performed.
 
 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
convey 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.
 
 Cost
of Revenue:
 
 Our cost
of product sales includes the costs we incur to formulate our finished products
into salable 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 consulting and other revenue
includes incremental out of pocket costs to provide consulting
services.  Cost of licensing fees and royalties is zero as there are
no incremental costs associated with the revenue.
 
 Cash
and cash equivalents:
 
 Cash and
cash equivalents include all highly liquid investments with original maturities
of three months or less at date of acquisition.  At times, the Company
maintains cash and cash equivalents in accounts in excess of the Federal Deposit
Insurance Corporation (“FDIC”) limits.
  40
 Table of Contents
 CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
  Inventories:
 
 Inventories
are stated at the lower of cost or market with cost determined using the average
cost method.  We assess the realizability of inventories by
periodically conducting a physical inventory and reviewing the movement of
inventory to determine the value of items that are slow moving and
obsolete.  The potential for near-term product engineering changes
and/or technological obsolescence and current realizability are considered in
determining the adequacy of inventory reserves.  At each of December
31, 2008 and 2007, our inventory reserves were $22,000.
 
 Fixed
Assets:
 
 Our fixed
assets, comprised of leasehold improvements, furniture and fixtures, purchased
software, office and computer equipment, are stated at
cost.  Depreciation is computed over the estimated useful lives of the
depreciable assets ranging from three to five years using the straight-line
method.  Depreciation expense was $91,000, $71,000 and $94,000 for the
years ended December 31, 2008, 2007 and 2006, respectively.
 
 Patents:
 
 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.  Indirect and other
patent-related costs are expensed as incurred.
 
 We
evaluate the remaining useful life of our patents at each reporting period to
determine whether events and circumstances warrant a revision to the remaining
period of amortization.  If the evaluation determines that the
patent’s remaining useful life has changed, the remaining carrying amount of the
patent is amortized prospectively over that revised remaining useful
life.  We also evaluate our patents for impairment whenever events or
other changes in circumstances indicate that the carrying amount may not be
recoverable.  The testing for impairment includes evaluating the
undiscounted cash flows of the asset and the remaining period of amortization or
useful life.  The factors used in evaluating the undiscounted cash
flows include current operating results, projected future operating results and
cash flows and any other material factors that may affect the continuity or the
usefulness of the asset.  If impairment exists or if we decide to
abandon a patent, the patent is written down to its fair value based upon
discounted cash flows.  At December 31, 2008 and 2007, the Company’s
patents, net were $1,027,000 and $817,000, respectively.
 
 Comprehensive
Loss:
 
 We report
comprehensive loss in accordance with Financial Accounting Standards Board
(“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 130,
“Reporting Comprehensive Income.”  The provisions of SFAS No. 130
require that the Company report the changes in stockholders’ equity from all
sources during the period other than those resulting from investments by and
distributions to stockholders.  Accordingly, the consolidated
statements of comprehensive loss are presented, while the caption “accumulated
other comprehensive loss” is included on the consolidated balance sheets as a
component of stockholders’ equity.  Due to availability of net
operating losses and the resultant deferred tax benefit being fully reserved,
there is no tax effect associated with any component of other comprehensive
loss.  Comprehensive loss is comprised of net loss and other
comprehensive income (loss).  Other comprehensive income (loss)
includes certain changes in stockholders’ equity that are excluded from net
loss, including foreign currency translation adjustments.
 
 Foreign
Currency Translation:
 
 Gains or
losses on foreign currency transactions are included in other income (expense)
in the consolidated statements of operations and aggregated a loss of $845,000
in 2008, a loss of $11,000 in 2007 and a gain of $104,000 in 2006.Prior
to 2006, the U.S. dollar was considered the functional currency for CD
International, the Company’s U.K. branch.  During 2006, the activities
of CD International increased, including transacting business in local
currency.  Accordingly, commencing in 2006, the functional currency
changed to the British pound sterling and thereafter assets and liabilities of
CD International are translated at the exchange rates in effect at the balance
sheet date, and revenue and expenses are translated at the average exchange
rates for the period.  The resulting foreign currency translation
adjustment of $(390,000) and $(20,000) for the years ended December 31, 2008 and
2007, respectively, is included in accumulated other comprehensive loss as a
component of stockholders’ equity.  The resulting effect of
remeasurement of CD International’s accounts into its functional currency as a
result of the change was not significant.  The Company’s policy is
that exchange differences arising from the translation of the balance sheets of
entities that have functional currencies other than the U.S. dollar are taken to
accumulated other comprehensive loss, a component of stockholders’
equity.  In entities where the U.S. dollar is the functional currency,
unrealized gains and losses due to remeasurement of monetary assets held in
currencies other than the U.S. dollar are reflected in foreign currency exchange
gain (loss) on the consolidated statement of operations.
  41
 Table of Contents
 CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
  Valuation
of Accounts Receivable:
 
 The
Company makes judgments as to the collectability of accounts receivable based
upon the historic trends and future expectations.  Management
estimates an allowance for doubtful accounts, which adjusts gross trade accounts
receivable downward to its estimated net realizable value.  To
determine the allowance for doubtful accounts, management reviews specific
customer risks and the accounts receivable aging.
 
 Basic
and Diluted Loss per Common Share:
 
 Basic and
diluted loss per share is calculated in accordance with SFAS No. 128, “Earnings
Per 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
2008, 2007 and 2006 does not include common share equivalents associated with
972,578, 812,800 and 648,100 options, respectively, and 424,992, 424,992 and
1,557,400 warrants, respectively, as the result would be
anti-dilutive.  Further, the per share effects of the common stock
subscribed and to be issued have not been included as the effect would be
anti-dilutive.
 
 Fair
Value of Financial Instruments:
 
 Our
instruments are carried at fair value (see below under caption
“Investments”).  Certain financial instruments are carried at cost on
our 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.
 
 Investments:
 
 The
Company’s investments consist of auction rate securities (“ARS”) and an auction
rate securities right (“ARSR”) (see Note 5).  The Company accounts for
its ARS investments using the provisions of SFAS No. 115, "Accounting for
Certain Investments in Debt and Equity Securities” and its ARSR investment using
the provisions of SFAS No. 159, “The Fair Value Option for Financial Assets and
Liabilities.”  SFAS No. 115 provides 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.
 
 SFAS No
159, which the Company adopted on January 1, 2008, 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 SFAS No.
157, “Fair Value Measurements,” which was adopted on January 1, 2008. SFAS 157
accomplishes the following key objectives:
  42
 Table of Contents
 CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
  ·
              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.
 
 In
October 2008, the FASB issued FASB Staff Position (“FSP”) FSP FAS
No. 157-3, “Determining the Fair Value of a Financial Asset When the Market
for That Asset Is Not Active” (“FSP FAS No. 157-3”), to provide
guidance on determining the fair value of financial instruments in inactive
markets.  FSP FAS No. 157-3 became effective for the Company upon
issuance.  This standard had no impact on the Company’s financial position,
results of operations or cash flows.
 
 Concentrations of
Credit Risk:
 
 Financial
instruments, which potentially subject us to concentration of credit risk,
consist of cash and cash equivalents, investments and accounts
receivables.  We maintain cash and cash equivalents in accounts with
various financial institutions in amounts which, at times, may be in excess of
the FDIC insurance limit.  We do not believe we are exposed to any
significant risk with respect to cash and cash equivalents.
 
 We sell
our products and services to distributors and end users in various industries
worldwide.  We regularly assess the realizability of accounts
receivable and also take into consideration the value of past due accounts
receivable and the collectibility of such receivables based upon credit
worthiness and historic collections from past due accounts.  We do not
require collateral or other security to support customer
receivables.
 
 Significant
Customers:
 
 In each
of the years ended December 31, 2008, 2007 and 2006, revenue derived from
certain customers comprised 10% or more of our consolidated revenue
(“significant customers”) as set forth in the table below:
 
 As
      a percentage of consolidated revenue:Years ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006Customer
      A
                    
                    
                    15.1
                    %
                    
                    
                    *
                    
                    
                    
                    *Customer
      B
                    
                    
                    *
                    
                    
                    
                    30.5
                    %
                    
                    
                    *Customer
      C
                    
                    
                    *
                    
                    
                    
                    24.3
                    %
                    
                    
                    *Customer
      D
                    
                    
                    *
                    
                    
                    
                    15.5
                    %
                    
                    
                    *Customer
      E
                    
                    
                    *
                    
                    
                    
                    *
                    
                    
                    
                    29
                    %Customer
      F
                    
                    
                    *
                    
                    
                    
                    *
                    
                    
                    
                    13
                    %
 
 *
              Represents less than 10% revenue
      for that customer in the applicable year.    There were no other
      customers that represented 10% or more of revenue for the years
      indicated.
  43
 Table of Contents
 CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
  At
December 31, 2008, no one customer represented greater than 10% of the Company’s
gross accounts receivable balance.  At December 31, 2007, the Company
had one customer that represented 57% of its gross accounts receivable balance
(Customer B).
 
 Stock-Based
Compensation:
 
 The
Company adopted SFAS No. 123 (Revised 2004), “Share Based Payment,” effective
January 1, 2006.  SFAS No. 123R requires the Company to measure the
cost of employee, officer and director services received in exchange for
stock-based awards at the fair value of the award on the date of
grant.
 
 Research
and Development Costs:
 
 Costs
relating to the research, development and testing of our technologies and
products are charged to operations as they are incurred.  These costs
include verification programs, evaluation and testing projects, salary and
benefits, consulting fees, materials and testing gear.
 
 Selling,
General and Administrative Expenses:
 
 Selling,
general and administrative expenses are comprised of the following:
 
 (in
      thousands)Years ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006Non-cash
      stock-based compensation
                    
                    $
                    1,204
                    
                    
                    $
                    1,966
                    
                    
                    $
                    304Severance
                    
                    
                    
                    
                    
                    
                    
                    
                    357Compensation
      and benefits
                    
                    
                    4,386
                    
                    
                    
                    2,997
                    
                    
                    
                    2,400Total
      compensation and benefits
                    
                    $
                    5,590
                    
                    
                    $
                    4,963
                    
                    
                    $
                    3,061Professional
      services
                    
                    
                    1,683
                    *
                    
                    
                    1,487
                    *
                    
                    
                    792Travel
                    
                    
                    712
                    
                    
                    
                    622
                    
                    
                    
                    538Occupancy,
      property and business taxes, supplies, postage and
delivery
                    
                    
                    859
                    
                    
                    
                    511
                    
                    
                    
                    406Sales
      and marketing expenses
                    
                    
                    400
                    
                    
                    
                    341
                    
                    
                    
                    279Bad
      debt expense
                    
                    
                    629
                    
                    
                    
                    28
                    
                    
                    
                    33Depreciation
      and all other
                    
                    
                    119
                    
                    
                    
                    89
                    
                    
                    
                    169Total
                    
                    $
                    9,992
                    
                    
                    $
                    8,041
                    
                    
                    $
                    5,278
 
 *  Includes
$227,000 of non-cash stock-based compensation charges for fair value of
warrants.
 
 Aggregate
non-cash share-based compensation charges incurred by the Company in 2008, 2007
and 2006, were $1,444,000, $2,208,000 and $304,000, respectively, all of which
was included in selling, general and administrative expenses, except $13,000 and
$14,000 in 2008 and 2007, respectively, included in research and development
expenses.
 
 Income
Taxes:
 
 Deferred
income taxes are provided for the tax effect of temporary differences between
the carrying amounts of assets and liabilities for financial reporting purposes
and the amounts used for tax purposes.
 
 Recent
Accounting Pronouncements (not yet adopted):
 
 In
February 2008, the FASB issued Staff Position 157-2 (“FSP
157-2”).  FSP 157-2 permits delayed adoption of SFAS 157 for 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 by FSP 157-2, the Company has
elected to delay the adoption of SFAS 157 for qualifying non-financial assets
and liabilities, such as fixed assets and patents.  The Company is in
the process of evaluating the impact, if any, that the application of SFAS 157
to its non-financial assets will have on the Company’s consolidated results of
operations or financial position.
  44
 Table of Contents
 CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
  In
December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business
Combinations” (“SFAS No. 141R”).  SFAS No. 141R 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.  SFAS No. 141R also
expands required disclosures surrounding the nature and financial effects of
business combinations.  SFAS No. 141R will be applied prospectively
for acquisitions beginning in 2009 or thereafter.
 
 In
December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in
Consolidated Financial Statements.”  SFAS No. 160 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.  The Company does not expect the adoption of
SFAS No. 160 to have a material impact on the Company’s financial
position, results of operations or cash flows.
 
 In March
2008, the FASB issued SFAS No. 161, "Disclosures about Derivative Instruments
and Hedging Activities" ("SFAS 161").  SFAS 161 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 under FASB Statement No. 133 and
its related interpretations and (c) how derivative instruments and related
hedged items affect a company’s financial position, results of operations and
cash flows.  The Company does not expect the adoption of
SFAS No. 161 to have a material impact on the Company’s financial
position, results of operations or cash flows.
 
 In April
2008, the FASB issued FSP FAS No. 142-3, “Determination of the Useful
Life of Intangible Assets”(“FSP
FAS No. 142-3”).  FSP FAS No. 142-3 amends the factors
that should be considered in developing renewal or extension assumptions used to
determine the useful life of a recognized intangible asset under
SFAS No. 142, Goodwill and Other Intangible Assets.  The intent
of this FSP 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 under SFAS No. 141 (revised 2007),
Business Combinations, and other US generally accepted accounting
principles.  FSP FAS No. 142-3 is effective for the Company for
fiscal years beginning after December 15, 2008.  The Company does not
expect this standard to have any material impact on the Company’s financial
position, results of operations or cash flows.
 
 In April
2008, the FASB issued EITF 07-05, “Determining Whether an Instrument (or
Embedded Feature) Is Indexed to an Entity’s Own Stock,” (“EITF
07-05”).  EITF 07-05 provides 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 paragraph 11(a) of SFAS No.
133.  EITF 07-05 is effective for financial statements issued for
fiscal years beginning after December 15, 2008 and early application is not
permitted.  The Company does not expect the adoption of EITF 07-05 to
have a material impact on the Company’s financial position, results of
operations or cash flows.
  45
 Table of Contents
 CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
  3.           Inventories
 
 Inventories
are comprised of the following:
 
 (in
      thousands)December 31,2008
                    
                    
                    2007Finished
      Platinum Plus fuel-borne catalyst
                    
                    $
                    144
                    
                    
                    $
                    165Platinum
      concentrate/metal
                    
                    
                    578
                    
                    
                    
                    656Hardware
                    
                    
                    268
                    
                    
                    
                    260Other
                    
                    
                    6
                    
                    
                    
                    34$
                    996
                    
                    
                    $
                    1,115Less:
      inventory reserves
                    
                    
                    (22
                    )
                    
                    
                    (22
                    )Inventories,
      net
                    
                    $
                    974
                    
                    
                    $
                    1,093
 
 At December 31, 2008 and 2007, U.S.
inventories were approximately 80% and foreign inventories were approximately
20% of the total inventories, net.
 
 4.         Patents
 
 Patents
held by the Company consist of capitalized patent costs net of accumulated
amortization and are as follows:
 
 (in
      thousands)December 31,2008
                    
                    
                    2007Patents
                    
                    $
                    1,220
                    
                    
                    $
                    975Less:
      accumulated amortization
                    
                    
                    (193
                    )
                    
                    
                    (158
                    )Patents,
      net
                    
                    $
                    1,027
                    
                    
                    $
                    817
 
 Patent
amortization expense for the years ended December 31, 2008, 2007 and 2006 was
$51,000, $41,000 and $44,000, respectively.  Patent amortization
expense for each of the five succeeding years based upon patents as of December
31, 2008 is estimated to be approximately $50,000 annually.  In each
of 2008, 2007 and 2006, the Company wrote off net patent costs in jurisdictions
the Company determined to abandon totaling approximately $38,000, $58,000 and
$23,000, respectively.
 
 5.         Investments
 
 In
accordance with SFAS No. 157, the Company’s investments as of 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)December
      31,2008
                            
                            
                            2007Auction
      rate securities
                            
                            $
                            10,235
                            
                            
                            $
                            18,825Auction
      rate securities right
                            
                            
                            1,305
                            
                            
                            ─Total
      investments
                            
                            $
                            11,540
                            
                            
                            $
                            18,825Classified
      as current assets
                            
                            
                            6,413
                            
                            
                            
                            7,100Classified
      as non-current assets
                            
                            $
                            5,127
                            
                            
                            $
                            11,725
 
 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 (elected pursuant to SFAS No. 159), with the
resultant gain recognized in operations.
  46
 Table of Contents
 CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
  At
December 31, 2007 and for the period through the date the Company accepted the
Offer, the Company classified the ARS as available-for-sale under SFAS No. 115.
Thereafter, the Company transferred the ARS to the trading
category.
 
 The fair
value of the ARS was approximately $10.2 million (par value of $11.7 million)
and $18.8 million (par value of $18.8 million) as of December 31, 2008 and 2007,
respectively.  We sold $7.1 million of these investments in
2008.  The fair value declined $1.5 million from par value in 2008,
which loss was charged to 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 the
ARSR at a fair value of $1.3 million and recognized the gain in operations,
which, together with the $1.5 million decline in fair value of the ARS, resulted
in a net charge to operations in 2008 of $0.2 million included in other
expense.  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.
 
 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 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 (see Notes 9 and 15).
 
 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.
 
 Accrued
interest receivable at December 31, 2008 and 2007 was approximately $11,000 and
$49,000, respectively.
 
 The table
below includes a rollforward of the Company’s investments in ARS and ARSR from
January 1, 2008 to December 31, 2008:
 
 (in
      thousands)Significant
                      Other
                      Observable
                      Inputs
                      (Level 2)
                    
                    
                    Significant
                      Unobservable
                      Inputs
                      (Level 3)Fair
      value, January 1, 2008
                    
                    $
                    18,825
                    
                    
                    $
                    —Purchases
                    
                    
                    —
                    
                    
                    
                    —Sales
                    
                    
                    (7,100
                    )
                    
                    
                    —Transfers
      (out) in
                    
                    
                    (11,725
                    )
                    
                    
                    11,725Unrealized
      loss included in statement of operations
                    
                    
                    —
                    
                    
                    
                    (185
                    )Fair
      value, December 31, 2008
                    
                    $
                    —
                    
                    
                    $
                    11,540Change
      in unrealized loss
                    
                    
                    
                    
                    
                    $
                    ( 185
                    )
  47
 Table of Contents
 CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
  6.         Accrued
Expenses
 
 Accrued
expenses are comprised of the following:
 
 (in
      thousands)December 31,2008
                    
                    
                    2007Professional
      fees
                    
                    $
                    168
                    
                    
                    $
                    264Accrued
      compensation
                    
                    
                    234
                    
                    
                    
                    254Accrued
      directors’ and technical advisory board fees
                    
                    ─
                    
                    
                    
                    44Accrual
      for inventory received
                    
                    ─
                    
                    
                    
                    106Value
      added taxes payable
                    
                    
                    9
                    
                    
                    
                    98Travel
      and all other
                    
                    
                    123
                    
                    
                    
                    84Accrued
      expenses
                    
                    $
                    534
                    
                    
                    $
                    850
 
 7.           Stockholders’
Equity
 
 Authorized
Capital Stock
 
 As of
December 31, 2008, the Company has 12.1 million shares authorized, 12 million
shares of which are $0.01 par value common stock and 100,000 of which are $0.01
par value preferred stock.  At the Company’s annual meeting of
stockholders held on June 7, 2007, the stockholders approved a five-to-one
reverse split of the Company’s common stock, a reduction of the par value of the
Company’s common stock from $0.05 per share to $0.01 per share and an increase
to the number of shares of common stock the Company is authorized to issue from
9 million to 12 million.  Such actions became effective on June 15,
2007 when the Company filed a Certificate of Amendment to its Restated
Certificate of Incorporation with the Secretary of State of
Delaware.  The historical share numbers and per share amounts in these
financial statements for all periods presented have been adjusted to give effect
to the reverse split.  At the Company’s annual meeting of stockholders
held on June 15, 2006, the stockholders approved an amendment to increase the
number of shares of common stock the Company is authorized to issue from 6
million to 9 million.  Such amendment became effective on June 21,
2006 when the Company filed a Certificate of Amendment to its Restated
Certificate of Incorporation with the Secretary of State of
Delaware.  The Company believes that there is a sufficient number of
shares authorized to cover its current needs.
 
 In 2007
in conjunction with the reverse split, we incurred costs aggregating
approximately $33,000, primarily from our transfer agents and outside legal
counsel which were charged to additional paid-in capital.  We also
charged an aggregate of $83,000 to additional paid-in capital for costs incurred
in connection with our filing of a Registration Statement on Form S-1 with the
SEC and approximately $52,000 related to our initial listing on The NASDAQ
Capital Market.  On October 3, 2007, our common stock began trading on
The NASDAQ Capital Market under the symbol “CDTI.”
 
 We
acquired 86 shares of our common stock from the fractional shares that were paid
in cash in lieu of fractional shares to stockholders as stockholders surrendered
old stock certificates for new stock certificates.  The cash value of
the fractional shares was determined based upon the average of our high and low
prices on June 15, 2007 on the U.S. Over-the-Counter market and the U.K. AIM of
the London Stock Exchange with the average AIM price translated at the foreign
exchange rate then in effect.  The Company retired all treasury shares
on August 9, 2007.
 
 Issuance
of Common Shares
 
 In 2008,
we issued 14,247 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.
 
 In 2008,
the Company charged approximately $14,000 to additional paid-in capital for
costs incurred in connection with our filing of a Post-effective Amendment to a
Registration Statement on Form S-1.
  48
 Table of Contents
 CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
  In 2007,
we issued 2,159,649 shares of our common stock as follows:
 
 Shares
      subscribed in the 2006 private placement
                    
                    
                    667,999Shares
      issued upon exercise of Class A warrants
                    
                    
                    699,883Shares
      issued upon exercise of Class B warrants
                    
                    
                    699,990Shares
      issued upon exercise of options
                    
                    
                    72,178Shares
      issued for services
                    
                    
                    19,5992,159,649
 
 We issued
667,999 shares of our common stock upon collection of approximately $4.3
million, net of expenses, representing all of the remaining subscriptions from
the December 2006 private placement (the private placement is outlined
below).
 
 We
received gross proceeds of $15.7 million from the exercise of 699,883 of our
Class A warrants and 699,990 of our Class B warrants.  The newly
issued shares are covered by an effective Registration Statement on file with
the Securities and Exchange Commission.  Proceeds from the exercise of
the Class A and B warrants, net of approximately $575,000 in placement agent
fees, totaled $15.2 million.  We also issued 143,432 five-year
warrants to the placement agent as additional compensation (see Note
8).  The proceeds from the exercise of warrants were used for general
corporate purposes.
 
 In 2007,
we issued 72,178 shares of our common stock upon exercise of 93,609
options.  In connection therewith, we received approximately $353,000
in cash and the surrender of 21,431 shares.
 
 In
January and June 2007, we issued 17,142 and 2,457, respectively, of our common
stock to non-executive members of our board of directors in lieu of
approximately $115,000 and $25,000 of directors’ fees earned for services
provided during the year ended December 31, 2006 and the first quarter of
2007.  In June 2006, the Company issued 12,438 shares of its common
stock to non-executive members of its board of directors in lieu of
approximately $94,000 of directors’ fees earned for services provided during the
year ended December 31, 2005.  The number of shares of our common
stock issued to the directors was determined based upon the average of the high
and low share prices during each quarter.  The grant date for such
shares of common stock for purposes of measuring compensation is the last day of
the quarter in which the shares are earned, which is the date that the director
begins to benefit from, or be adversely affected by, subsequent changes in the
price of the stock.  Directors’ compensation charged to operations did
not materially differ from such measurement.
 
 On
December 29, 2006, the Company secured commitments for the purchase of 1,400,000
shares of its common stock, par value $0.01, and warrants for the purchase of an
additional 1,400,000 shares of common stock for aggregate gross cash proceeds of
$9.5 million (net proceeds of approximately $9.0 million).  Of such
total, $5.0 million ($4.7 million, net) had been received by December 31, 2006
and comprised 732,001 shares of our common stock.  Of the remaining
balance of $4.5 million ($4.3 million, net), $2.5 million was paid by
subscribers by March 23, 2007.  This amount, net of the related
placement fee of approximately $0.1 million, was classified in current assets as
subscriptions receivable on the December 31, 2006 balance sheet and represented
373,554 shares of our common stock.  Net subscriptions receivable of
$1.9 million (net of the related placement fees of approximately $0.1 million)
that had not paid as of March 23, 2007 was classified as a reduction of
stockholders’ equity at December 31, 2006 and represented 294,444 shares of our
common stock.  The securities were sold in investment units consisting
of one share of common stock, one Class A warrant and one Class B warrant, each
warrant entitling the holder to purchase one additional share of common stock
for every two shares of common stock acquired in the offering at a purchase
price of $6.75 per unit (see Note 8).  The material terms of the
agreements between the Company and the investors were as follows:
 
 (i)
              The
      Company sold and the investors bought units of one share of common stock
      and warrants (effectively, one-half of each of Class A and B warrants) to
      buy one share of common stock for the consideration of $6.75 per
      unit;
 
 (ii)
              The
      investors represented that they were acquiring the shares, the warrants
      and the shares of common stock underlying the warrants for their own
      accounts as an investment, and undertook with respect to these securities
      to comply with the transfer restrictions of Regulation S or Regulation D
      under the Securities Act of 1933, as the case may
  be;
  49
 Table of Contents
 CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
  (iii)
              The
      Company undertook to apply for the listing of its outstanding shares on
      the American Stock Exchange or another recognized U.S. stock exchange at
      such time as the Company should satisfy the applicable listing
      requirements; and
 
 (iv)
              The
      Company undertook to file a registration statement under the Securities
      Act of 1933 covering the shares and the shares of common stock underlying
      the warrants following completion of the audit of its financial statements
      for the year 2006.  The agreements did not contain a penalty
      provision for the Company’s failure to file that registration
      statement.
 
 In
connection with the offering, the Company incurred expenses including initial
commissions to the placement agent of approximately $410,000.  In
addition, the Company agreed to issue warrants to the placement agent for the
purchase of 140,542 shares of the Company’s common stock, at an exercise price
of $8.44 per share expiring on December 29, 2011, as additional compensation for
services, subject to the availability of authorized shares of common stock not
otherwise committed.
 
 8.         Stock
Options and Warrants
 
 Stock
Options
 
 The
Company maintains an equity 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 10 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.  In general, the
policy of the board of directors is to grant stock options that vest in equal
amounts on the date of grant and the first and second anniversaries of the date
of grant, except that awards to non-executive members of the board of directors
typically vest immediately.
 
 The
Company estimates the fair value of stock options using a Black-Scholes
valuation 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.  SFAS No. 123R
requires forfeitures to be estimated at the time of grant in order to estimate
the amount of share-based awards ultimately expected to vest.  The
estimate is based on the Company’s historical rates of
forfeitures.  SFAS No. 123R 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.
  50
 Table of Contents
 CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
  The
weighted-average fair values at the date of grant for options granted during the
years ended December 31, 2008, 2007 and 2006 were $3.18, $11.65 and $7.47,
respectively, and were estimated using the Black-Scholes option pricing model
with the following weighted-average assumptions:
 
 Years ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006Expected
      term in years
                    
                    
                    8.84
                    
                    
                    
                    8.75
                    
                    
                    
                    8.64Risk-free
      interest rate
                    
                    
                    2.46%
                    
                    
                    
                    2.38%
                    
                    
                    
                    4.56%Expected
      volatility
                    
                    
                    89.1%
                    
                    
                    
                    97.5%
                    
                    
                    
                    104.7%Dividend
      yield
                    
                    
                    0%
                    
                    
                    
                    0%
                    
                    
                    
                    0%
 
 Share-based
compensation expense recognized by the Company in 2008 and 2007 includes
compensation expense for share-based awards based on the grant date fair value
estimated in accordance with the provisions of SFAS No.
123R.  Share-based compensation expense recognized by the Company in
2006 included (i) compensation expense for share-based awards granted prior to,
but not yet vested as of December 31, 2005, based on the grant date fair value
estimated in accordance with the pro forma provisions of SFAS No. 123 and (ii)
compensation expense for the share-based payment awards granted subsequent to
December 31, 2005, based on the grant date fair value estimated in accordance
with the provisions of SFAS No. 123R.
 
 For the
years ended December 31, 2008, 2007 and 2006, share-based compensation for
options and warrants was $1,444,000, $2,208,000 and $304,000,
respectively.  Compensation costs for stock options which vest over
time are recognized over the vesting period.  As of December 31, 2008,
the Company had $1.0 million of unrecognized compensation cost related to
granted stock options and warrants that remained to be recognized over vesting
periods.  These costs are expected to be recognized over a weighted
average period of one year.
 
 The
following table summarizes the Company’s stock option activity and related
information for the years ended December 31:
 
 2008
                                            
                                            
                                            2007
                                            
                                            
                                            2006Shares
                                            
                                            
                                            Weighted
                                              Average
                                              Exercise
                                              Price
                                            
                                            
                                            Shares
                                            
                                            
                                            Weighted
                                              Average
                                              Exercise
                                              Price
                                            
                                            
                                            Shares
                                            
                                            
                                            Weighted
                                              Average
                                              Exercise
                                              PriceOutstanding
      at beginning of year
                                            
                                            
                                            812,844
                                            
                                            
                                            $
                                            11.72
                                            
                                            
                                            
                                            648,087
                                            
                                            
                                            $
                                            10.08
                                            
                                            
                                            
                                            649,187
                                            
                                            
                                            $
                                            10.31Options
      granted
                                            
                                            
                                            202,500
                                            
                                            
                                            $
                                            4.18
                                            
                                            
                                            
                                            291,166
                                            
                                            
                                            $
                                            14.57
                                            
                                            
                                            
                                            21,000
                                            
                                            
                                            $
                                            8.32Options
      exercised
                                            
                                            
                                            (27,166
                                            )
                                            
                                            $
                                            10.37
                                            
                                            
                                            
                                            (93,609
                                            )
                                            
                                            $
                                            7.55
                                            
                                            
                                            
                                            (3,000
                                            )
                                            
                                            $
                                            4.50Options
      expired
                                            
                                            
                                            (1,500
                                            )
                                            
                                            $
                                            10.00
                                            
                                            
                                            
                                            (20,333
                                            )
                                            
                                            $
                                            23.02
                                            
                                            
                                            
                                            (9,667
                                            )
                                            
                                            $
                                            23.08Options
      forfeited
                                            
                                            
                                            (14,100
                                            )
                                            
                                            $
                                            11.19
                                            
                                            
                                            
                                            (12,467
                                            )
                                            
                                            $
                                            6.17
                                            
                                            
                                            
                                            (9,433
                                            )
                                            
                                            $
                                            10.00Outstanding
      at end of year
                                            
                                            
                                            972,578
                                            
                                            
                                            $
                                            10.19
                                            
                                            
                                            
                                            812,844
                                            
                                            
                                            $
                                            11.72
                                            
                                            
                                            
                                            648,087
                                            
                                            
                                            $
                                            10.08Options
      exercisable at year-end
                                            
                                            
                                            780,744
                                            
                                            
                                            $
                                            10.62
                                            
                                            
                                            
                                            657,177
                                            
                                            
                                            $
                                            11.21
                                            
                                            
                                            
                                            597,931
                                            
                                            
                                            $
                                            10.41Options
      available for grant atyear-end
                                            
                                            
                                            451,625
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            608,866
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            144,853Weighted-average
      fair value ofoptions
      granted during the year
                                            
                                            
                                            
                                            
                                            
                                            $
                                            3.18
                                            
                                            
                                            
                                            
                                            
                                            
                                            $
                                            11.65
                                            
                                            
                                            
                                            
                                            
                                            
                                            $
                                            7.47Aggregate
      intrinsic value –options
      exercised
                                            
                                            
                                            
                                            
                                            
                                            $
                                            288,414
                                            
                                            
                                            
                                            
                                            
                                            
                                            $
                                            880,974
                                            
                                            
                                            
                                            
                                            
                                            
                                            $
                                            3,000Aggregate
      intrinsic value –options
      outstanding
                                            
                                            
                                            
                                            
                                            
                                            $
                                            —Aggregate
      intrinsic value –options
      exercisable
                                            
                                            
                                            
                                            
                                            
                                            $
                                            —
  51
 Table of Contents
 CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
  The
following table summarizes information about stock options outstanding at
December 31, 2008:
 
 Options Outstanding
                  
                  
                  Options ExercisableRange of
                    Exercise Prices
                  
                  
                  Number
                    Outstanding
                  
                  
                  Weighted
                    Average
                    Remaining
                    Contractual
                    Life
                    (In Years)
                  
                  
                  Weighted
                    Average
                    Exercise
                    Price
                  
                  
                  Number
                    Exercisable
                  
                  
                  Weighted
                    Average
                    Exercise
                    Price$2.705
                  
                  
                  
                  174,500
                  
                  
                  
                  9.98
                  
                  
                  
                  $    
        2.71
                  
                  
                  
                  80,500
                  
                  
                  
                  $    
        2.71$3.60 
      –  $7.875
                  
                  
                  
                  119,767
                  
                  
                  
                  5.49
                  
                  
                  
                  $    
        5.63
                  
                  
                  
                  114,767
                  
                  
                  
                  $    
        5.57$8.25
       –  $9.10
                  
                  
                  
                  199,910
                  
                  
                  
                  7.23
                  
                  
                  
                  $     
       8.78
                  
                  
                  
                  161,244
                  
                  
                  
                  $    
        8.73$9.20  –  $10.125
                  
                  
                  
                  128,200
                  
                  
                  
                  4.81
                  
                  
                  
                  $      
      9.65
                  
                  
                  
                  128,200
                  
                  
                  
                  $   
         9.65$12.50 
      –  $16.50
                  
                  
                  
                  184,700
                  
                  
                  
                  3.35
                  
                  
                  
                  $    
      14.28
                  
                  
                  
                  178,867
                  
                  
                  
                  $    
      14.28$16.99 
      –  $19.125
                  
                  
                  
                  165.501
                  
                  
                  
                  8.98
                  
                  
                  
                  $    
      18.97
                  
                  
                  
                  117,167
                  
                  
                  
                  $    
      19.05$2.705 
      –  $19.125
                  
                  
                  
                  972,578
                  
                  
                  
                  6.75
                  
                  
                  
                  $    
      10.19
                  
                  
                  
                  780,744
                  
                  
                  
                  $    
      10.62
 
 Warrants
 
 In 2008,
there was no activity in the Company's 424,992 outstanding
warrants.
 
 In 2007,
we issued 50,000 warrants to an adviser on the Company’s investor
matters.  The computed fair value of the warrants was approximately
$455,000 and was estimated using the Black-Scholes option pricing model with the
following assumptions:  five year expected term, 4.04% risk-free
interest rate, 77.6% expected volatility and 0% dividend yield.  The
fair value of this warrant is being expensed over the four-month term of the
agreement.  We included $227,000 of this stock compensation in our
selling, general and administrative expenses in 2007.  Also in 2007,
we issued the remaining 74,142 warrants, representing the balance due the
placement agent for the 2006 private placement (see below).  The
computed fair value of the placement agent’s 140,542 warrants was approximately
$748,000 and was estimated using the Black-Scholes option pricing model with the
following assumptions:  five year expected term, 4.65% risk-free
interest rate, 83.2% expected volatility and 0% dividend yield.  There
was no accounting impact on our financial statements because the fair value
chargeable to stockholders’ equity was fully offset by the corresponding credit
to stockholders’ equity.  Further, we are obligated to issue the
placement agent 143,432 warrants as partial compensation for the financings
generated upon exercise of our Class A and B warrants (see below).  Of
this amount, 70,255 are exercisable at $12.50 per share and expire on July 2,
2012 and 73,177 warrants are exercisable at $15.625 per share and expire on
December 29, 2012.  The computed fair value of the placement agent’s
143,432 warrants was approximately $1,599,000 and was estimated using the
Black-Scholes option pricing model with the following
assumptions:  five year expected term, 3.63% and 4.65% risk-free
interest rates, 77.3% and 80.3% expected volatility and 0% dividend
yield.  There was no accounting impact on our financial statements
because the fair value chargeable to stockholders’ equity was fully offset by
the corresponding credit to stockholders’ equity.
 
 In 2007,
1,399,873 warrants were exercised for total gross proceeds of $15.7 million (net
proceeds of $15.2 million).  The warrants exercised were those that
had been issued in connection with the 2006 private placement and included
699,883 of our Class A warrants and 699,990 of our Class B
warrants.
 
 As
discussed in Note 7, the December 2006 private placement offered investment
units that consisted of one share of common stock, one Class A warrant and one
Class B warrant.  The Class A and B warrants were immediately
exercisable.  The Class A warrants entitled the holder until July 2,
2007 to purchase, at a price of $10.00 per share, one share of common stock for
every two shares of common stock acquired in the offering.  The Class
B warrants entitled the holder until December 29, 2007 to purchase, at a price
of $12.50 per share, one share of common stock for every two shares of common
stock acquired in the offering.  Based upon 1,400,000 investment units
sold and subscribed, an aggregate of 0.7 million of each of Class A and Class B
warrants were issuable.  In addition, the Company agreed to issue
five-year warrants to purchase 140,542 shares of the Company’s common stock, at
an exercise price of $8.44 per share, to the placement agent as additional
compensation for its services, subject to the availability of authorized capital
not otherwise committed (the initial number of warrants agreed to be issued was
66,400).  The Company’s warrant activity for the year December 31,
2006 included warrants to be issued comprised of 0.7 million Class A warrants,
0.7 million Class B warrants and 66,400 of the warrants due to the placement
agent.
  52
 Table of Contents
 CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
  Warrant
activity for the years ended December 31 is summarized as follows:
 
 2008
                      
                      
                      2007
                      
                      
                      2006Shares
                      
                      
                      Weighted
                        Average
                        Exercise
                        Price
                      
                      
                      Shares
                      
                      
                      Weighted
                        Average
                        Exercise
                        Price
                      
                      
                      Shares
                      
                      
                      Weighted
                        Average
                        Exercise
                        PriceOutstanding
      at beginning of year
                      
                      
                      424,992
                      
                      
                      $
                      11.35
                      
                      
                      
                      1,557,424
                      
                      
                      $
                      10.98
                      
                      
                      
                      101,346
                      
                      
                      $
                      8.84Warrants
      to be issued
                      
                      ─
                      
                      
                      $ ─
                      
                      
                      
                      143,432
                      
                      
                      $
                      14.09
                      
                      
                      
                      1,466,400
                      
                      
                      $
                      11.13Warrants
      issued
                      
                      ─
                      
                      
                      $ ─
                      
                      
                      
                      124,142
                      
                      
                      $
                      11.67
                      
                      
                      ─
                      
                      
                      $
                      ─Warrants
      exercised
                      
                      ─
                      
                      
                      $ ─
                      
                      
                      
                      (1,399,873
                      )
                      
                      $
                      11.25
                      
                      
                      ─
                      
                      
                      $
                      ─Warrants
      expired / forfeited
                      
                      ─
                      
                      
                      $ ─
                      
                      
                      
                      (133
                      )
                      
                      $
                      7.71
                      
                      
                      
                      (10,322
                      )
                      
                      $
                      10.00Outstanding
      and to be issuedat
      end of year
                      
                      
                      424,992
                      
                      
                      $
                      11.35
                      
                      
                      
                      424,992
                      
                      
                      $
                      11.35
                      
                      
                      
                      1,557,424
                      
                      
                      $
                      10.98Warrants
      exercisable at year-end
                      
                      
                      424,992
                      
                      
                      $
                      11.35
                      
                      
                      
                      424,992
                      
                      
                      $
                      11.35
                      
                      
                      
                      1,557,424
                      
                      
                      $
                      10.98Aggregate
      intrinsic value
                      
                      
                      
                      
                      
                      $─
                      
                      
                      
                      
                      
                      
                      $
                      4,953,662
                      
                      
                      
                      
                      
                      
                      $
                      102,325
 
 The
following table summarizes information about warrants outstanding as of December
31, 2008:
 
 Warrants Outstanding and
      ExercisableRange
      of
                                Exercise Prices
                              
                              
                              Number
                                Outstanding
                                And
                                Exercisable
                              
                              
                              Weighted
                                Average
      Remaining
                                Contractual
                                Life
                                (In Years)
                              
                              
                              Weighted
      Average
                                Exercise
                                Price$    
      7.50 – $8.15
                              
                              
                              
                              63,053
                              
                              
                              
                              3.54
                              
                              
                              $  7.97$     
                  
      8.44
                              
                              
                              
                              140,542
                              
                              
                              
                              3.00
                              
                              
                              $ 8.44$  10.00
      - $16.45
                              
                              
                              
                              221,397
                              
                              
                              
                              3.53
                              
                              
                              $
      14.15424,992
                              
                              
                              
                              3.35
                              
                              
                              $
      11.35
 
 9.         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 on May 8,
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 may not exceed 50% of the value of our ARS as determined
by the lender.  No facility fee was required.  Borrowings
bear interest at a floating interest rate per annum equal to the sum of the
prevailing daily 30-day Libor plus 25 basis points.  Interest expense
for the year ended December 31, 2008 was $56,000.
 
 In
November 2008, the Company accepted the Offer from UBS AG (see Note
5).  UBS committed to loan us 75% of the value of the ARS as
determined by UBS at any time until the ARS right is exercised.  We
applied for the loan which UBS committed would be on a no net cost basis to the
Company.  UBS approved our application on January 14, 2009 (see Note
15 “Subsequent Events”).
 
 10.         Commitments
 
 The
Company is 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 that expires December 2015 for its relocated U.S.
headquarters (5,515 square feet) at an annual cost of approximately $141,000,
including utilities.  The Company is obligated under a one-year lease
through July 2009 for 2,750 square feet of warehouse space at an annual cost of
approximately $21,000, including utilities.  In addition, the Company
is obligated under a 64-month lease through March 2013 for 1,942 square feet of
administrative space in the U.K. at an annual cost of approximately $65,000,
including utilities and parking.  For the years ended December 31,
2008, 2007 and 2006, rental expense approximated $225,000, $205,000 and
$181,000, respectively.  Our contractual obligations for each of the
next five years ended December 31 are as follows: $201,000, $175,000, $186,000,
$186,000 and $163,000; and $304,000 thereafter.
  53
 Table of Contents
 CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
  Effective
October 28, 1994, Fuel-Tech N.V., 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 is obligated to pay Fuel Tech a royalty of 2.5% of its annual
gross revenue attributable to sales of the platinum fuel
catalysts.  The royalty obligation expired in 2008.  CDT, as
assignee and owner, maintains the technology at its expense.  Royalty
expense incurred under this obligation in 2008, 2007 and 2006 amounted to
$20,700, $14,300 and $14,500, respectively.  Royalties payable to Fuel
Tech at December 31, 2008 and 2007 amounted to $20,700 and $14,300,
respectively.
 
 11.         Related
Party Transactions
 
 The
Company has a Management and Services Agreement with Fuel Tech that requires the
Company to reimburse Fuel Tech for management, services and administrative
expenses incurred on its behalf at a rate from 3% to 10% of the costs paid on
the Company’s behalf, dependent upon the nature of the costs
incurred.  For the last three years, the Company has reimbursed Fuel
Tech for the expenses associated with one Fuel Tech officer/director who also
serves as an officer/director of CDT.  The Company’s financial
statements include charges from Fuel Tech of certain management and
administrative costs of approximately $70,000, $71,000 and $70,000 for the years
ended December 31, 2008, 2007 and 2006, respectively.  The Company
believes the charges under this Management and Services Agreement are reasonable
and fair.  The Company and Fuel Tech terminated the Management and
Services Agreement effective February 1, 2009.
 
 As
outlined in Note 7, we issued 19,599 and 12,438 shares of our common stock in
2007 and 2006, respectively, to non-executive members of our board of directors
in lieu of approximately $25,000, $115,000, and $94,000 of directors’ fees
earned in the first quarter of 2007 and the years ended December 31, 2006 and
2005, respectively.  Such directors’ fees had been accrued and charged
to expense during the respective periods.  The number of shares of our
common stock issued to the directors was determined based upon the average of
the high and low share prices during each quarter.  The grant date for
such shares of common stock for purposes of measuring compensation is the last
day of the quarter in which the shares are earned, which is the date that the
director begins to benefit from, or be adversely affected by, subsequent changes
in the price of the stock.  Directors’ compensation charged to
operations did not materially differ from such measurement.
 
 In
conjunction with the December 2006 private placement (see Note 7), directors and
management invested $106,321 for a total of 15,751 common shares and 15,751
warrants.  In 2007, all of such warrants were exercised by the
directors and management or assignees of them.  During 2007, directors
and management exercised 14,446 of these warrants for an aggregate of $162,749
to acquire 14,446 shares of common stock.
 
 12.         Technology
Licensing Agreements and Other Revenue
 
 In each
of 2008 and 2007, we executed license agreements with new licensees for our
selective catalytic reduction (SCR) emission control (our patented ARIS
technologies for control of oxides of nitrogen) and the combination of exhaust
gas recirculation (EGR) with SCR technologies.  The agreements
provided for up-front fees and quarterly per-unit royalty payments during the
term of the licenses.  The licenses will stay in effect for the
remaining life of the underlying patents.  The licenses are
non-exclusive and cover specific geographic territories.  For the year
ended December 31, 2008, technology licensing fees and royalties totaled
$451,000.  The year ended December 31, 2007 includes approximately
$3.5 million in technology licensing fees and royalties, including approximately
$0.2 million from an existing licensee’s September 2004 license and $0.5 million
due to amendment of a license agreement with an existing
licensee.
  54
 Table of Contents
 CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
  Consulting
and Other
 
 The 2006
revenue included consulting fees from services rendered on various projects,
including provision of certain consulting and market analysis services pursuant
to a consulting contract.
 
 13.         Income
Taxes
 
 The
Company follows the liability method of accounting for income
taxes.  Such method requires recognition of deferred tax liabilities
and assets for the expected future tax consequences of events that have been
included in the financial statements or tax returns.  Deferred tax
liabilities and assets are determined based on the difference between the
financial statement and tax bases of assets and liabilities using enacted tax
rates in effect for the year in which the differences are expected to
reverse.
 
 As of
December 31, 2008, the Company has tax losses available for offset against
future years’ taxable income of approximately $48.4 million, of which $9.5
million will expire over the next five years and the remaining tax losses expire
from 2018 through 2028.  The Company also has research and development
tax credit carryforwards of approximately $1.8 million, expiring between 2011
and 2028.  The Company has provided a full valuation allowance to
reduce the related deferred tax asset to zero because of the uncertainty
relating to realizing such tax benefits in the future.  The total
valuation allowance increased by $3.3 million during the year ended December 31,
2008.  Deferred tax assets and valuation allowance at December 31,
2008 and 2007 are as follows:
 
 December 31,2008
                                      
                                      
                                      2007Research
      and development
                                      
                                      $
                                      1,789
                                      
                                      
                                      $
                                      1,746Net
      operating loss carryforwards
                                      
                                      
                                      18,867
                                      
                                      
                                      
                                      16,229Reserves
                                      
                                      
                                      140
                                      
                                      
                                      Options
                                      
                                      
                                      968
                                      
                                      
                                      
                                      531Deferred
      tax assets
                                      
                                      
                                      21,764
                                      
                                      
                                      
                                      18,506Less:
      valuation allowance
                                      
                                      
                                      (21,764
                                      )
                                      
                                      
                                      (18,506
                                      )Deferred
      tax assets, net
                                      
                                      $
                                      
                                      
                                      
                                      $
                                      
 
 We
adopted FASB Interpretation No. 48 (“FIN 48”) effective January 1,
2007.  There were no unrecognized tax benefits at the date of adoption
of FIN 48, and there were no unrecognized tax benefits at December 31, 2007 and
2008.  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 rights offering to a maximum annual allowance
of $735,000.  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
$2,519,000.  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 2005 through 2008 remain open to
examination by various taxing jurisdictions as the statute of limitations has
not expired.
  55
 Table of Contents
 CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
  Reconciliations
of the differences between income taxes computed at federal statutory rates
(34%) and consolidated provisions (benefits) for income taxes for the years
ended December 31, 2008, 2007 and 2006 are as follows:
 
 Years ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006Federal
      taxes (benefits) at statutory rates
                    
                    
                    (34%
                    )
                    
                    
                    (34%
                    )
                    
                    
                    (34%
                    )State
      taxes (benefits) rate
                    
                    
                    (5%
                    )
                    
                    
                    (5%
                    )
                    
                    
                    (5%
                    )Change
      in valuation allowance
                    
                    
                    39%
                    
                    
                    
                    39%
                    
                    
                    
                    39%Income
      taxes (benefits)
                    
                    %
                    
                    
                    %
                    
                    
                    %
 
 14.           Geographic
Information
 
 CDT sells
its products and licenses its technologies throughout the world.  A
geographic distribution of revenue consists of the following:
 
 (in
      thousands)Years ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006U.S.
                    
                    $
                    905
                    
                    
                    $
                    2,563
                    
                    
                    $
                    684Europe
                    
                    
                    6,405
                    
                    
                    
                    2,255
                    
                    
                    
                    117Asia
                    
                    
                    165
                    
                    
                    
                    107
                    
                    
                    
                    322Total
      revenue
                    
                    $
                    7,475
                    
                    
                    $
                    4,925
                    
                    
                    $
                    1,123
 
 The Company has patent coverage in
North and South America, Europe, Asia, Africa and Australia.  As of
December 31, 2008 and 2007, the Company’s assets comprise the
following:
 
 (in
      thousands)December 31,2008
                    
                    
                    2007U.S.
                    
                    $
                    17,214
                    
                    
                    $
                    22,680Foreign
                    
                    
                    1,533
                    
                    
                    
                    1,983Total
      assets
                    
                    $
                    18,747
                    
                    
                    $
                    24,663
 
 15.         Subsequent
Events
 
 In
January 2009, we received $3.4 million proceeds from UBS under the approved no
net cost loan (see Note 9).  UBS approved a $6.5 million credit
facility based upon acceptance of our credit application pursuant to its
Offer.  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.  At March 4, 2009, the principal amount of the loan
outstanding amounted to $6.4 million ($3.0 million borrowed in July 2008 and
$3.4 million in January 2009).
 
 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.  In addition, Dr. Steiner
will receive approximately $47,317 in respect of the 2008 incentive
plan.  The Company expects to incur a severance charge of
approximately $510,000 in the first quarter of 2009 in connection with Dr.
Steiner’s departure to be paid in monthly installments until September
2010.
  56
 Table of Contents
 CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
  16.         Quarterly
Financial Data (unaudited)
 
 The table
below presents the Company’s unaudited quarterly information for the last eight
quarters.
 
 
 Three Months Ended2008
                                      
                                      March 31
                                      
                                      
                                      June 30
                                      
                                      
                                      September 30
                                      
                                      
                                      December 31Total
      revenue
                                      
                                      $
                                      2,601
                                      
                                      
                                      $
                                      2,619
                                      
                                      
                                      $
                                      1,580
                                      
                                      
                                      $
                                      675Gross
      profit *
                                      
                                      
                                      536
                                      
                                      
                                      
                                      626
                                      
                                      
                                      
                                      406
                                      
                                      
                                      
                                      190Net
      loss attributable to common stockholders
                                      
                                      
                                      (1,590
                                      )
                                      
                                      
                                      (2,143
                                      )
                                      
                                      
                                      (2,381
                                      )
                                      
                                      
                                      (3,259
                                      )Basic
      and diluted net loss per common share
                                      
                                      
                                      (0.20
                                      )
                                      
                                      
                                      (0.26
                                      )
                                      
                                      
                                      (0.29
                                      )
                                      
                                      
                                      (0.40
                                      )
  Three Months Ended2007
                            
                            March 31
                            
                            
                            June 30
                            
                            
                            September 30
                            
                            
                            December 31Total
      revenue
                            
                            $
                            216
                            
                            
                            $
                            1,243
                            
                            
                            $
                            2,460
                            
                            
                            $
                            1,006Gross
      profit *
                            
                            
                            100
                            
                            
                            
                            1,138
                            
                            
                            
                            2,293
                            
                            
                            
                            268Net
      (loss) income attributable to common stockholders
                            
                            
                            (1,815
                            )
                            
                            
                            (519
                            )
                            
                            
                            651
                            
                            
                            
                            (2,852
                            )Basic
      and diluted net (loss) income per common share
                            
                            
                            (0.30
                            )
                            
                            
                            (0.08
                            )
                            
                            
                            0.09
                            
                            
                            
                            (0.38
                            )
 
 *  Gross
profit is defined as total revenue less total cost of revenue.
  57
 Table of Contents
 CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
  Item9.
              Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
 
 None.
 
 Item9A.
              Controls
      and Procedures
 
 (a) Disclosure
Controls and Procedures.As
of the end of the period covered by this report, we carried out an evaluation,
under the supervision and with the participation of our management, including
our Chief Executive Officer and Chief Financial Officer, of the effectiveness of
the design and operation of our disclosure controls and procedures, as such term
is defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act.  Based
upon that evaluation, our Chief Executive Officer and Chief Financial Officer
concluded that as of the end of the period covered by this report, our
disclosure controls and procedures were effective to ensure that information
required to be disclosed by us in reports we file or submit under the Exchange
Act is (1) recorded, processed, summarized and reported within the time
periods specified in SEC rules and forms, and (2) accumulated and
communicated to our management, including our Chief Executive Officer and Chief
Financial Officer, to allow timely decisions regarding required
disclosure.
 
 (b) Management’s
Annual Report on Internal Control over Financial Reporting.Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting, as such term is defined in Rule 13a-15(f) of
the Exchange Act.  Under the supervision and with the participation of our
management, including our Chief Executive Officer and Chief Financial Officer,
we conducted an evaluation of the effectiveness of our internal control over
financial reporting based upon the framework in Internal Control – Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission.  Based on that evaluation, our management concluded
that our internal control over financial reporting is effective as of
December 31, 2008.
 
 Attestation
Report of the Registered Public Accounting Firm.  Eisner LLP,
an independent registered public accounting firm, has audited the consolidated
financial statements included in this Annual Report on Form 10-K and, as part of
their audit, has issued their report, included below, on the effectiveness of
our internal control over financial reporting.
 
 REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
 
 Board of
Directors and Stockholders
 Clean
Diesel Technologies, Inc.
 
 We have
audited the internal control over financial reporting of Clean Diesel
Technologies, Inc. and subsidiary (the “Company”) as of December 31, 2008,
based on criteria established inInternal
Control—Integrated Framework issued by the Committee of Sponsoring Organizations
of the Treadway Commission. The Company’s management is responsible for
maintaining effective internal control over financial reporting and for its
assessment of the effectiveness of internal control over financial reporting,
included in the accompanying Management’s Annual Report on Internal Control over
Financial Reporting. Our responsibility is to express an opinion on the
Company’s internal control over financial reporting based on our
audit.
 
 We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we
plan and perform the audit to obtain reasonable assurance about whether
effective internal control over financial reporting was maintained in all
material respects. Our audit included obtaining an understanding of
internal control over financial reporting, assessing the risk that a material
weakness exists, testing and evaluating the design and operating effectiveness
of internal control based on the assessed risk, and performing such other
procedures as we considered necessary in the circumstances.  We believe
that our audit provides a reasonable basis for our opinion.
 
 A
company’s internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company’s internal control
over financial reporting includes those policies and procedures that
(1) pertain to the maintenance of records that, in reasonable detail,
accurately and fairly reflect the transactions and dispositions of the assets of
the company; (2) provide reasonable assurance that transactions are
recorded as necessary to permit preparation of financial statements in
accordance with generally accepted accounting principles, and that receipts and
expenditures of the company are being made only in accordance with
authorizations of management and directors of the company; and (3) provide
reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of the company’s assets that could have a
material effect on the financial statements.
  58
 Table of Contents
 CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
  Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of the
effectiveness to future periods are subject to the risk that the controls may
become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.
 
 In our
opinion, the Company maintained, in all material respects, effective internal
control over financial reporting as of December 31, 2008, based on the
criteria established in Internal Control—Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission.
 
 We have
also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated balance sheets of Clean Diesel
Technologies, Inc. and subsidiary as of December 31, 2008 and 2007, and the
consolidated results of their operations and their cash flows for each of the
years in the three-year period ended December 31, 2008, and our report dated
March 13, 2009 expressed an unqualified opinion thereon, and included an
explanatory paragraph with respect to the Company’s adoption of Statement of
Financial Accounting Standard No. 159, “The Fair Value Option for Financial
Assets and Liabilities.”
 
 
 /s/  Eisner
LLP
 New York,
New York
 March 13,
2009
 
 
 (c) Changes in
Internal Control over Financial Reporting.The
Company is continuously seeking to improve the efficiency and effectiveness of
its operations and of its internal controls.  This results in refinements
to processes throughout the year.  We continue to enhance the design
and documentation of our internal control processes to ensure suitable controls
over our financial reporting.
 
 There
were no changes in our internal control over financial reporting that have
materially affected, or are reasonably likely to materially affect, our internal
control over financial reporting during our fourth fiscal quarter of
2008.
 
 Item9B.
              Other
      Information
 
 None.
  59
 Table of Contents
 CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
  Part
III
 
 Item10.
              Directors,
      Executive Officers and Corporate
Governance
 
 Information
required by this item regarding directors and executive officers of the Company
will be set forth under the captions “Election of Directors,” “Directors and
Executive Officers of Clean Diesel Technologies,” “Section 16(a) Beneficial
Ownership Reporting Compliance,” “Committees of the Board,” “Audit Committee”
and “Audit Committee Financial Experts” in the Company’s proxy statement related
to the 2009 annual meeting of stockholders and is incorporated by
reference.  Information regarding our directors is available on our
Internet site under “Investors” as follows:
http://www.cdti.com/corporate.html.
 
 The
Company has adopted a code of Ethics and Business Conduct (the “Code”) that
applies to all employees, officers and Directors, including the Chief Executive
Officer and Chief Financial Officer.  A copy of the code is available
free of charge on written or telephone request to the secretary of the Company
at the address or telephone number of the Company set out in the Company’s
annual report to stockholders.  The Code may also be viewed on our
website under “Investors” as follows:
http://www.cdti.com/corporate.html.
 
 Item11.
              Executive
      Compensation
 
 Information
required by this item will be set forth under the caption “Executive
Compensation,” “Directors’ Compensation,” “Report of Compensation and Nominating
Committee on Executive Compensation” and “Compensation and Nominating Committee
Interlocks and Insider Participation” in the proxy statement related to the 2009
annual meeting of stockholders and is incorporated by reference.
 
 Item12.
              Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
 
 Information
required by this item will be set forth under the caption “Principal
Stockholders and Stock Ownership of Management” in the proxy statement related
to the 2009 annual meeting of stockholders and is incorporated by
reference.
 
 Item13.
              Certain
      Relationships and Related Transactions, and Director
      Independence
 
 Information
required by this item will be set forth under the captions “Compensation and
Nominating Committee Interlocks and Insider Participation,” “Certain
Relationships and Related Transactions” and “Director Independence” in the proxy
statement related to the 2009 annual meeting of stockholders and is incorporated
by reference.
 
 Item14.
              Principal
      Accounting Fees and Services
 
 Information
required by this item will be set forth under the caption “Audit Fees” in the
proxy statement related to the 2009 annual meeting of stockholders and is
incorporated by reference.
  60
 Table of Contents
 CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
  Part
IV
 
 Item15.
              Exhibits
      and Financial Statement Schedules
 
 (a)
              (1)  Financial
      Statements
 
 The
Financial Statements identified below and required by Part II, Item 8 of this
Form 10-K are set forth above.
 Report of
Independent Registered Public Accounting Firm
 
 Consolidated
Balance Sheets as of December 31, 2008 and 2007
 
 Consolidated
Statements of Operations and Comprehensive Loss for the years ended December 31,
2008, 2007 and 2006
 
 Consolidated
      Statements of Changes in Stockholders’ Equity for the years ended December
      31, 2008, 2007 and 2006
 
 Consolidated
Statements of Cash Flows for the years ended December 31, 2008, 2007 and
2006
  (2)  Financial
Statement Schedules
 
 The
following financial statement schedule is included herein and should be read in
conjunction with the consolidated financial statements referred to
above.
 
 Valuation
and Qualifying Accounts – Page 64
 
 Other
schedules have been omitted because of the absence of the conditions under which
they are required or because the required information where material is shown in
the consolidated financial statements or the notes thereto.
 
 (b)
              Exhibits
 
 The
following exhibits are, as indicated by reference symbol, filed herewith or
incorporated by reference.  Portions of Exhibits 10(o) and 10(p) have
been omitted pursuant to a request for confidential treatment.
 
 3(i)(a)
                  
                  Restated
      Certificate of Incorporation dated as of March 21, 2007 (incorporated by
      reference to Exhibit 3(i)(a) to Annual Report on Form 10-K filed on March
      20, 2007).3(i)(b)
                  
                  Certificate
      of Amendment to Restated Certificate of Incorporation dated as of June 15,
      2007 (incorporated by reference to Exhibit 3(i)(b) to Registration
      Statement on Form S-1 [No. 333-144201] dated on June 29,
      2007).3(i)(c)
                  
                  Certificate
      of Elimination of Series A Convertible Preferred Stock dated June 18, 2004
      (incorporated by reference to Exhibit to Registration Statement on Form
      S-8 [No. 333-117057] dated July 1, 2004).3(ii)
                  
                  By-Laws
      as amended through November 6, 2008 (incorporated by reference to Exhibit
      3.1 to Quarterly Report on Form 10-Q filed on November 10,
      2008).4
                  
                  Specimen
      Stock Certificate, Common Stock (incorporated by reference to Exhibit to
      Registration Statement on Form S-1 (No. 33-95840) dated as of August 16,
      1995).10(a)
                  
                  Assignment
      of Intellectual Property Rights by Fuel-Tech N.V. to Platinum Plus, Inc.
      as of November 5, 1997 (incorporated by reference to Exhibit to Form 10-K
      for the year ended December 31,
1997).
  61
 Table of Contents
 
 10(b)
                  
                  Assignment
      of Intellectual Property Rights by Fuel Tech, Inc. to Clean Diesel
      Technologies, Inc. as of November 5, 1997 (incorporated by reference to
      Exhibit to Form 10-K for the year ended December 31,
  1997).10(c)
                  
                  Assignment
      Agreement as of November 5, 1997 among Platinum Plus, Inc., Fuel-Tech N.V.
      and Clean Diesel Technologies, Inc. (incorporated by reference to Exhibit
      to Form 10-K for the year ended December 31, 1997).10(d)
                  
                  Incentive
      Plan as amended through June 11, 2002 (incorporated by reference to
      Exhibit 10(d) to Annual Report on Form 10-K filed on March 30,
      2007).10(e)
                  
                  Form
      of Incentive Stock Option Agreement (incorporated by reference to Exhibit
      10(g) to Annual Report on Form 10-K filed on March 30,
    2007).10(f)
                  
                  Form
      of Non-Qualified Stock Option Agreement (incorporated by reference to
      Exhibit 10(h) to Form 10-K filed on March 30, 2007).10(g)
                  
                  Form
      of Non-Executive Director Stock Option Agreement (incorporated by
      reference to Exhibit to Registration Statement on Form S-8 [No.
      333-117057] dated July 1, 2004).10(h)
                  
                  Management
      Services Agreement between Clean Diesel Technologies, Inc., Fuel Tech,
      Inc. and Fuel-Tech N.V. as of June 1, 1996 (incorporated by reference to
      Exhibit to Form 10-Q for the quarter ended September 30,
      1996).10(i)
                  
                  Office
      Lease dated as of January 29, 2004 (incorporated by reference to Exhibit
      to Form 10-Q for quarter ended June 30, 2004).10(j)
                  
                  Registration
      Rights Agreement between Clean Diesel Technologies, Inc. and Fuel-Tech
      N.V. of November 5, 1997 (incorporated by reference to Exhibit to Form
      10-K for the year ended December 31, 1997).10(k)
                  
                  Registration Rights Agreement
      between Clean Diesel Technologies, Inc. and Fuel-Tech N.V. of March 24,
      1997 (incorporated by reference to Exhibit to Form 10-K for the year ended
      December31, 1996).10(l)
                  
                  Registration
      Rights Agreement between Clean Diesel Technologies, Inc. and the holders
      of Series A Convertible Preferred Stock as of November 11, 1998
      (incorporated as reference to Exhibit to Form 10-Q for the period ended
      September 30, 1998).10(m)
                  
                  License
      Agreement of July 13, 2001 between Clean Diesel Technologies, Inc. and
      Mitsui Co., Ltd  as amended by Amendment No. 1 of December
      18,  2002 (incorporated as reference to Exhibit to Form 10-Q for
      quarter ended June 30, 2004).10(n)
                  
                  License
      Agreement of March 31, 2003 between Clean Diesel Technologies, Inc. and
      Combustion Components Associates, Inc. (incorporated by reference to
      Exhibit to Exhibit to Form 10-Q for quarter ended June 30,
      2004).10(o)
                  
                  Employment
      Agreement dated September 23, 2003 between Tim Rogers and the Company
      (incorporated by reference to Exhibit10(x) to Annual Report on Form 10-K
      filed on March 30, 2007).10(p)
                  
                  Employment
      Agreement dated June 14, 2005 between Walter Copan and the Company
      (incorporated by reference to Exhibit to Form 8-K dated as of August 3,
      2005).10(q)
                  
                  Employment
      Agreement dated November 29, 2006 between Ann B. Ruple and the Company
      (incorporated by reference to Exhibit 10(z) to Annual Report on Form 10-K
      filed on March 30,
2007).
  62
 Table of Contents
 
 10(r)
                          
                          Employment
      Agreement dated as of January 1, 2008 between Bernhard Steiner and the
      Company.#10(s)
                          
                          Employment
      Agreement dated August 21, 2008 and
      Addendum thereto dated August 26, 2008 between Michael Asmussen and
      the Company.#10(t)
                          
                          Office
      lease dated as of September 2008.14
                          
                          Code
      of Ethics and Business Conduct (incorporated by reference to Exhibit to
      Annual Report on Form 10-K for the year ended December 31,
      2004).#21
                          
                          Subsidiaries.#23(a)
                          
                          Consent
      of Eisner LLP.#31(a)
                          
                          Section
      302 CEO Certification.#31(b)
                          
                          Section
      302 CFO Certification.#32
                          
                          Section
      906 Certification by CEO and CFO.- -
      - - - - - - - - - - - - - - - - - - - - - - - - - - - -
  -#
                          
                          Filed
      herewith.
  63
 Table of Contents
  Clean
Diesel Technologies, Inc. and Subsidiary
 SCHEDULE
II – VALUATION AND QUALIFYING ACCOUNTS
 Accounts
Receivable Allowance
 
 
 (in
      thousands)
                                      
                                      Balance at Beginning of
    Period
                                      
                                      
                                      Additions
      Charged to Costs and Expenses
                                      
                                      
                                      Additions
      Charged to Other Accounts
                                      
                                      
                                      Deductions*
                                      
                                      
                                      Balance at End of PeriodYear
      EndedDecember
      31, 2006
                                      
                                      $
                                      11
                                      
                                      
                                      $
                                      34
                                      
                                      
                                      $
                                      -
                                      
                                      
                                      $
                                      11
                                      
                                      
                                      $
                                      34December
      31, 2007
                                      
                                      $
                                      34
                                      
                                      
                                      $
                                      28
                                      
                                      
                                      $
                                      -
                                      
                                      
                                      $
                                      13
                                      
                                      
                                      $
                                      49December
      31, 2008
                                      
                                      $
                                      49
                                      
                                      
                                      $
                                      629
                                      
                                      
                                      $
                                      -
                                      
                                      
                                      $
                                      319
                                      
                                      
                                      $
                                      359* Uncollected
      receivables written off, net of recoveries and translation
      adjustment
  64
 Table of Contents
  SIGNATURES
 
 Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, Clean Diesel Technologies, Inc. has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.
 
 CLEAN
      DIESEL TECHNOLOGIES, INC.March 16, 2009
                          
                          By:
                          /s/   Michael L.
      AsmussenDate
                          
                          
                          Michael
      L. AsmussenChief
      Executive Officer, President and
Director
 
 
 Pursuant
to the requirements of the Securities Exchange Act of 1934, the following
persons on behalf of Clean Diesel Technologies, Inc. and in the capacities and
on the date indicated have duly signed this report below.
 
 
 /s/   Michael L.
      Asmussen
                
                Chief
      Executive Officer, President and DirectorMichael
      L. Asmussen
                
                (principal
      executive officer)/s/   Ann B.
Ruple
                
                Chief
      Financial Officer, Vice President and TreasurerAnn
      B. Ruple
                
                (principal
      financial and accounting officer)/s/   John A. de
      Havilland
                
                DirectorJohn
      A. de Havilland/s/   Derek R.
    Gray
                
                Director,
      Non-Executive Chairman of the Board of DirectorsDerek
      R. Gray/s/   Charles W.
      Grinnell
                
                Director,
      Vice President and Corporate SecretaryCharles
      W. Grinnell/s/   John J.
    McCloy
                
                DirectorJohn
      J. McCloy/s/   David F.
      Merrion
                
                DirectorDavid
      F. Merrion/s/   David
Gammon
                
                DirectorDavid
      Gammon
 
 
 Dated:  March
16, 2009
   65