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, 2007
 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.: 0-27432
 
 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
702, 300 Atlantic Street
 Stamford,
CT  06901
  (Address
of principal executive offices) (Zip Code)
 
 Registrant’s
telephone number, including area code:  (203)
327-7050
 
 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
Section 12(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. £
 
  Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
  Large
      Accelerated filer £
              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, 2007 was
$97,376,673.
 
 As of
March 7, 2008, the outstanding number of shares of the registrant’s common
stock, par value $0.01 per share, was 8,137,650.
 
 Documents incorporated by
reference:
 
 Certain
portions of the proxy statement for the annual meeting of stockholders to be
held on May 13, 2008 are incorporated by reference into Part III of this
report.
 CLEANDIESEL TECHNOLOGIES, INC.
 
 Annual
Report on Form 10-K
 For
the Fiscal Year Ended December 31, 2007
 
 
 Table of
Contents
 
 PART
      I1.
              
              Business
              
              31A.
              
              Risk Factors
              
              141B.
              
              Unresolved Staff Comments
              
              182.
              
              Properties
              
              183.
              
              Legal Proceedings
              
              184.
              
              Submission of Matters to a Vote of Security
      Holders
              
              18PART
      II5.
              
              Market for Registrant’s Common Equity, Related Stockholders’
      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
              
              328.
              
              Consolidated Financial Statements and Supplementary
      Data
              
              339.
              
              Changes in and Disagreements with Accountants on Accounting
      and Financial Disclosure
              
              559A.
              
              Controls and Procedures
              
              559B.
              
              Other Information
              
              56PART
      III10.
              
              Directors, Executive Officers and Corporate
      Governance
              
              5711.
              
              Executive Compensation
              
              5712.
              
              Security Ownership of Certain Beneficial Owners and
      Management and Related Stockholder Matters
              
              5713.
              
              Certain Relationships and Related Transactions, and
      Director Independence
              
              5714.
              
              Principal Accounting Fees and Services
              
              57PART
      IV15.
              
              Exhibits and Financial Statement
    Schedules
              
              58SIGNATURES
              
              
              
              61
 
 
 
 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
2008 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 “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.
 
 At our
annual meeting of stockholders held on June 7, 2007, our stockholders approved a
five-for-one reverse split of our common stock, a reduction of the par value of
our stock from $0.05 per share to $0.01 per share and an increase in our
authorized number of shares of common stock to 12,000,000 shares.  We
effected the reverse split of our common stock at 6:00 p.m. EDT on June 15,
2007, upon our filing of a Certificate of Amendment to our Restated Certificate
of Incorporation with the Secretary of State of Delaware.  Pursuant to
the reverse split, each then outstanding five shares of $0.05 par value of our
common stock was exchanged for one share of $0.01 par value of our common
stock.
 
 Effective
October 3, 2007, our common stock began trading in the U.S. on The NASDAQ
Capital Market.  Previously, our common stock traded in the U.S. on
the Over-The-Counter (OTC) Bulletin Board.
  3
 Table of Contents
    ·
              we
      licensed to Robert Bosch GmbH, a Stuttgart, Germany limited liability
      company, our selective catalytic reduction (SCR) emission control and the
      combination of exhaust gas recirculation (EGR) with SCR technologies; this
      worldwide license is non-exclusive.
 
 ·
              we
      executed a non-exclusive license agreement with Combustion Components
      Associates (CCA) that covers our patented ARIS®
      technologies for control of oxides of nitrogen using selective catalytic
      reduction for licensed territories of North America and
      Europe.
 
 ·
              we
      entered into a worldwide, non-exclusive license agreement with Tenneco
      Automotive Operating Company, Inc. (Tenneco) that covers our patented ARIS
      technologies for control of oxides of nitrogen using selective catalytic
      reduction.
 
 ·
              we
      consented to the assignment of a mobile retrofit license from CCA to
      Tenneco, as then amended, and terminated our original equipment
      manufacturer (OEM) license agreement with
CCA.
 
 ·
              we
      received a London Low Emission Zone (LEZ) Certificate from Transport for
      London for our Purifier particulate matter emission control technology
      that enables us to market Purifier as a retrofit solution to commercial
      operators owning older vehicles.
 
 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 provides for annual royalties
commencing in 1998 and terminating 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.  We may terminate this royalty
obligation at any time by payment to Fuel Tech of $1.1 million in
2008.
 
 In 2007,
we filed 68 patent applications.  In 2006, we filed three U.S. and
five foreign patent applications.  During 2005, we filed ten U.S. and
two foreign patent applications.  Also in 2005, we acquired 11 granted
foreign patents and two U.S. and eight foreign patent applications.
 
 As of
December 31, 2007, we held 148 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, 2007 includes 27 U.S. patents and approximately 121 corresponding
foreign patents along with 119 pending U.S. and foreign patent
applications.  Our scientists and engineers continue to make invention
disclosures for which we are in the process of preparing patent
applications.  Our patents have expiration dates ranging from 2008
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.
 
 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);
  4
 Table of Contents
  ·
              carbon
      dioxide (CO2);
 ·
              carbon
      monoxide (CO); and
 ·
              hydrocarbon
      (HC).
 
 Our core
patents, advanced patents and patent applications include the
following:
 
 ·
              Fuel-borne
      catalyst;
 ·
              Selective
      catalytic reduction;
 ·
              Catalyzed
      wire mesh filter;
 ·
              Biofuels;
      and
 ·
              Emission
      control systems.
 
 Our key
technologies include the following:
 
 ·
              The
      cost effective means of controlling the four 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.  Patent
filing, prosecution, maintenance and annuity fees for our extensive patent
portfolio are a significant portion of our expenses.  Patent-related
expenses were $364,000, $235,000 and $170,000 for the years ended December 31,
2007, 2006 and 2005, 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 licensing agreements are usually
structured so that we derive revenue from license fees and on-going
royalties.  In 2008, we will seek broader market coverage by
strengthening our marketing and distribution channels through training existing
distributors and engaging new distributors.  In 2008, we will also
stress direct selling of our solutions and products to fleets in various
industries by emphasizing the environmental benefits, fuel economy improvements
and practical, lower cost emission control available from the use of our
solutions and products.  We intend to create the market pull 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; the ARIS®, an
advanced reagent injection system used in selective catalytic reduction systems
for control of emissions of nitrogen oxides from diesel engines; our diesel
particulate filter technology based on catalyzed wire mesh filter elements; and
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.
 
 Fleet
tests using Platinum Plus fuel-borne catalyst have shown improvements in fuel
economy of up 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.) 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 the EPA registration in December 1999 for the Platinum Plus fuel-borne
catalyst for use in bulk fuel by refiners, distributors and truck
fleets.  In 2000, we completed the certification protocol for
particulate filters and additives for use with particulate filters with VERT,
the main recognized authority in Europe that tests and verifies diesel
particulate filters for emissions and health effects.  In 2001, the
Swiss environmental agency BUWAL approved the Platinum Plus fuel-borne catalyst
for use with particulate filters.  In 2002, the U.S. Mining, Safety
and Health Administration accepted Platinum Plus fuel-borne catalyst for use in
all underground mines.
 
 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 System).  This system is now being promoted as a
solution for cost-effective emissions reduction.
 
 EPA
verification is given for specific engine groups, and the initial verification
and applications are for pre-1996 manufactured engines, which are higher
emitters of particulates and nitrogen oxides than newer engines.  We
also received verification extension for the fuel-borne catalysts with
diesel-oxidation catalysts to cover engines manufactured between 1994 and
2003.  Verification is needed for the end user of the Platinum Plus
fuel-borne catalyst systems to get emissions reduction credit from the EPA’s
voluntary retrofit program or California Air Resources Board’s mandatory
retrofit program.  In the U.S., truck fleets, municipalities and
off-road equipment operators are generally moving toward using only verified
technologies when installing retrofit emissions reduction systems, and such
verified technologies are typically mandated for governmentally funded
projects.
  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.  The 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 being 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 our partners and distributors 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 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 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 the passenger car manufacturers.  We anticipate
penetration into this market as we proceed through 2008.
 
 Platinum
PlusforFuel
Economy
 
 We
believe that recent increases in the cost of fuel have 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 have 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, our customers derive economic benefits
from the use of our Platinum Plus fuel-borne catalyst whenever the price of
diesel fuel is in excess of $1.75 per U.S. gallon.  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 2007,
we conducted four large, on-road fleet fuel economy demonstration trials in a
range of industries, including the beverage, waste management, grocery and fuel
delivery industries, for the purpose of demonstrating the fuel economy benefits
and emission reduction attributable to Platinum Plus fuel-borne
catalyst.  We also conducted two marine trials, one for a marine ferry
operation and the other for a barge operation.  The improvements in
fuel economy from using Platinum Plus fuel-borne catalyst in these
demonstrations ranged up to 12% with an average 8% improvement.  The
best results were generally attributable to short-haul “stop-and-go” driving, as
is generally the pattern for local delivery vehicles, buses and garbage
trucks.  Lab engine test beds run at OEM test labs and independent
research institutes showed up to 8% improvement in fuel economy in modern diesel
engines, which have been confirmed by field testing programs.
 
 Platinum
Plusfor
Biodiesel
 
 Platinum
Plus fuel-borne catalyst is effective with regular sulfur diesel, ultra-low
sulfur diesel, arctic diesel (kerosene) and biodiesel.  When used with
blends of biodiesel and ultra-low sulfur diesel, our 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.
 
 ARIS
Selective Catalytic Reduction
 
 The ARIS
(Advanced Reagent Injection System) is our patented injection 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 trucks, buses,
trains and boats.  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 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.  The 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.
  7
 Table of Contents
  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.  We have verified the system under the EPA’s Environmental
Technology Verification protocol as reducing toxic particulates by up to 76%,
carbon monoxide by 60%, hydrocarbons by 80% and nitrogen oxides by
9%.  It also provides lower nitrogen dioxide emissions levels relative
to traditional, heavily catalyzed filter systems.  In 2005, the
catalyzed wire mesh filter technology was transferred to us under a technology
transfer agreement with Mitsui and PUREarth.  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.
 
 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.
 
 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 beverage delivery vehicles, refuse trucks and
buses.  We received EPA Environmental Technology Verification in June
2004 for the catalyzed wire mesh filter system, which combines the Platinum Plus
fuel-borne catalyst with a catalyzed wire mesh filter.
 
 The
Market and the Regulatory Environment
 
 We
estimate that worldwide annual consumption of diesel fuel exceeds 250 billion
U.S. gallons, including approximately 50 billion in the U.S., 65 billion in
Europe and 75 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.
 
 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 2008 and
2010.  European engine manufacturers have 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 significant intellectual property
holdings for the design and implementation of these systems.
  8
 Table of Contents
  In May
2004, the EPA announced proposals to regulate non-road engines.  The
regulations will be phased in from 2008 to 2014.  Proposals include a
wide range of construction equipment, agricultural equipment, as well as
railroad and marine applications.
 
 We
believe the U.S. market for diesel engines is poised for significant growth
because of the 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 2008 to
2010 period.
 
 Existing
Diesel Engines and the Retrofit Market
 
 While
much of the regulatory pressure and the response from engine manufacturers have
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 there are approximately 11
million diesel powered vehicles which need to be retrofitted over the next ten
years.  We believe this trend underlies the 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.
 
 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 to
reduce emissions on school buses and the Smartway Transport Program to reduce
both diesel emissions and fuel consumption on over-the-road trucks.
 
 Competition
 
 Because
our principal strategy is the licensing of our technologies, those companies
that could be considered as competitors and as potential licensees of ours
should also be considered as our potential customers.
 
 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 and other companies offer products that
potential customers may consider to be acceptable alternatives.  In
addition, newly developed products could be more effective and cost-efficient
than our current products or those developed in the future.
 
 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.  Moreover, many of the current and potential future
competitors have substantially more financial, engineering, sales and marketing
capabilities, and broader product lines than we do.  Because of
greater resources, these competitors may be better able to withstand a change in
conditions within the industries in which we operate, a change in the prices of
raw materials or a change in global economic conditions.  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 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 reduction 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 Argillon (acquired by Johnson Matthey in 2007),
Hilite International and KleenAir Systems for retrofit, and Bosch and Hilite
International for OEMs.  Bosch entered into a worldwide, non-exclusive
technology license agreement with us in 2007 for the right to use our
proprietary technology for a single fluid system which requires no compressed
air.
  9
 Table of Contents
  Sales
and Marketing
 
 Our
products and solutions are sold to customers through our distribution network,
direct sales and the efforts of our sales consultants and agents.  As
of February 29, 2008, our sales and marketing team consisted of ten employees,
sales consultants and agents supported by our executive officers and members of
our board of directors.
 
 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.
 
 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 requirements for emissions compliance and the high cost of fuel
make the use of our products economical.  With diesel fuel selling at
approximately $3.50 per U.S. gallon, or more, in the United States as of
February 2008, a fuel savings of as little as 3% corresponds to $0.105 per U.S.
gallon and effectively pays the cost of dosing with Platinum Plus fuel-borne
catalyst by diesel fleet operators.  Our Platinum Plus fuel-borne
catalyst in controlled fleet tests showed an average of 8% 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.
  10
 Table of Contents
  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
towards 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 markets,
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 verified 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.  We have received verification from
the EPA for two systems based upon the use of the Platinum Plus fuel-borne
catalyst.  Our family of Platinum Plus Purifier Systems uses the
fuel-borne catalyst and a diesel oxidation catalyst for up to a 50% particulate
reduction.  Another system of ours is verified for up to 75% reduction
and uses a catalyzed wire mesh filter and the Platinum Plus fuel-borne
catalyst.  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
royalties 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 and from a warehouse in the northeast of 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 plan to widen distribution by selling
key components with the technology licenses.  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 the catalyzed wire mesh filter technology which we have acquired by
selling products based upon that technology alone and in combination with our
Platinum Plus fuel-borne catalyst.  We have developed new 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.
 
 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 CDT 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.
  11
 Table of Contents
  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.
 
 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 EPA-verified Platinum Plus
Purifier System, our fuel-borne catalyst and a diesel-oxidation catalyst, and
catalyzed wire mesh filters, including EPA-verified 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, 2007, 2006 and 2005.
 
 (dollars
      in thousands)For
      the years ended December 31,2007
              
              
              2006
              
              
              2005Product
      sales
              
              $
              1,466
              
              
              
              29.8
              %
              
              $
              860
              
              
              
              76.6
              %
              
              $
              760
              
              
              
              93.6
              %License
      and royalty revenue
              
              
              3,459
              
              
              
              70.2
              %
              
              
              74
              
              
              
              6.6
              %
              
              
              47
              
              
              
              5.8
              %Consulting
      and other
              
              
              
              
              
              
              
              
              189
              
              
              
              16.8
              %
              
              
              5
              
              
              
              0.6
              %Total
              
              $
              4,925
              
              
              
              100.0
              %
              
              $
              1,123
              
              
              
              100.0
              %
              
              $
              812
              
              
              
              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, 2007, 2006 and 2005 are outlined in
Note 12 of Notes to Consolidated Financial Statements.
  12
 Table of Contents
  Our
Platinum Plus fuel-borne catalyst concentrate and finished product are sold to
distributors, resellers and vehicle fleets in various industries, including
beverage, grocery, shipping, fuel delivery and marine, among other end
users.  We license the ARIS nitrogen oxides reduction system 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.The market price for platinum has
generally increased over the last several years.  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 test programs, salary and benefits,
consulting fees, materials and certain testing equipment and are charged to
operations as they are incurred.  Our research and development
expenses, exclusive of patent costs, totaled approximately $428,000, $510,000
and $439,000, respectively, for the years ended December 31, 2007, 2006 and
2005.
 
 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.
 
 Employees
 
 As of
February 29, 2008, we had sixteen full-time employees and one part-time
employee.  In addition, one executive officer of Fuel Tech provides
management and legal services to us as needed pursuant to a Management and
Services Agreement with Fuel Tech.  We also retain outside consultants
and sales and marketing consultants and agents.
 
 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.
  13
 Table of Contents
  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 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
far greater financial, technological, manufacturing and personnel resources,
including BASF (formerly Engelhard), Donaldson, Cummins Filtration, Innospec
(formerly Octel), Rhodia, Hilite International, Johnson Matthey (including
Argillon which it acquired in 2007) and KleenAir Systems.  Newly
developed products could be more effective and cost efficient than our current
or future products.  Many of the current and potential future
competitors have substantially more engineering, sales and marketing
capabilities and broader product lines than we have.  We also face
indirect competition from vehicles using alternative fuels, such as methanol,
hydrogen, ethanol and electricity.
  14
 Table of Contents
  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 patent, will expire 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 assurances 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.
 
 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.
 ·
              Continued
      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, $1,118 per
ounce at December 31, 2006 and $1,530 per ounce at December 31,
2007.  On February 22, 2008, the London Metal Exchange afternoon
fixing for platinum was $2,155 per ounce.  Although we intend to
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.
  15
 Table of Contents
  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 manufacturing 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.
 
 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 $49.5 million as of December 31, 2007,
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
resources are estimated to be sufficient for our needs through December 31, 2008
and beyond.
 
 We have
recognized limited revenues through December 31, 2007 and expect to continue to
incur operating losses at least through 2008.  There can be no
assurance that we will achieve or sustain significant revenues or profitability
in the future.  See the discussion below under the caption “Liquidity
and Sources of Capital” 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.  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
Sources of Capital” in Item 7, “Management’s Discussion and Analysis of
Financial Condition and Results of Operations.”
  16
 Table of Contents
  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
are currently 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.
 
 A few
customers currently account for a significant portion of our
revenues.  For the year ended December 31, 2007, three customers
accounted for approximately 70% of our revenue and for the years ended December
31, 2006 and 2005, two customers accounted for approximately 42% and 36%,
respectively, of our revenue, primarily attributable to license fees and
royalties, product sales and consulting fees.  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.
 
 Foreign
currency fluctuations could impact financial performance.
 
 Our
recent operating activities have primarily been in the U.S.  However,
we haveincreased
ouractivities in 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.  There can be no assurance that foreign currency
fluctuations will not have a significant effect on our operations in the
future.
 
 Capital
market conditions may influence our ability to liquidate
investments.
 
 At
December 31, 2007, we held a total of $18.1 million in investments in auction rate
securities, most of which were AAA/Aaa rated and collateralized by student loans
substantially guaranteed by the U.S. Department of Education.The Company
sold approximately $7.1 million in auction rate securities subsequent to
December 31, 2007.  However, starting on February 15, 2008, the Company
experienced difficulty in selling additional securities because of the failure
of the auction mechanism as a result of sell orders exceeding buy
orders.  Liquidity for these auction ratesecurities is
typically provided by an auction process that resets the applicable interest
rate at pre-determined intervals.  These failed auctions represent
market risk exposure and are not defaults or credit events.  Holders
of the securities continue to receive interest on the investment, currently at a
pre-determined maximum rate, and the securities will be auctioned every 28 days
until the auction succeeds, the issuer calls the securities, or they
mature.  Accordingly, because there may be no effective mechanism for
selling these securities, the securities may be viewed
as long-term assets.  The funds associated with failed auctions
will not be accessible until a successful auction occurs or a buyer is found
outside of the auction process.  We classified $11.7 million of these
auction rate securities as non-current investments as of December 31,
2007.  At this time, the Company does not believe such securities are
impaired or that the failure of the auction mechanism will have a material
impact on the Company’s liquidity or financial
position.
 
 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.
  17
 Table of Contents
  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 2007 was approximately 26,000
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.
 
 Item1B.
              Unresolved
      Staff Comments
 
 None.
 
 Item2.
              Properties
 
 We have a
five-year lease expiring in March 2009 for 3,925 square feet of administrative
office space at 300 Atlantic Street, Stamford, Connecticut.  The
annual cost of the lease including rent, utilities and parking is approximately
$128,000.  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 (excluding utilities) through July 2008.
 
 Item3.
              Legal
      Proceedings
 
 We are
not involved in any legal proceedings.
 
 Item4.
              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 2007.
  18
 Table of Contents
  Part
II
 
 Item5.
              Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities
 
 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 symbols “CDT” and “CDTS” (this latter symbol
denotes restricted shares that have been issued in private placements) and on
the Frankfurt exchange under the symbol “CDI”.At February 29, 2008,
there were 169 holders of record of our common stock representing approximately
1,500 beneficial holders.
 
 No
dividends have been paid on our common stock and we do not anticipate paying
cash dividends in the foreseeable future.  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.
 
 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)20061st
      Quarter
              
              $
              5.80
              
              
              $
              4.00
              
              
              £
              3.25
              
              
              £
              2.252nd
      Quarter
              
              $
              9.75
              
              
              $
              5.30
              
              
              £
              5.00
              
              
              £
              2.903rd
      Quarter
              
              $
              9.75
              
              
              $
              7.00
              
              
              £
              5.00
              
              
              £
              3.604th
      Quarter
              
              $
              9.00
              
              
              $
              7.25
              
              
              £
              4.85
              
              
              £
              3.9020071st
      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
              
              
              £
              6.10
 
 Sales
and Uses of Unregistered Securities During the Period
 
 The shares of common stock issued
during the year pursuant to stock subscriptions entered into in December 2006
and the shares of common stock issued upon exercise of warrants are registered
for resale by a Registration Statement on Form S-1 that was declared effective
by the SEC on October 4, 2007.
 
 On July
2, 2007, we sold shares of our common stock upon the exercise of
warrants.  We received gross proceeds of $7.1 million from the
exercise of warrants to acquire seven-hundred nine thousand, three-hundred
eighty-three (709,383) of the Company’s common shares.  The warrants
were exercised by 35 investors (31 non-U.S. investors and 4 U.S.
investors).  The warrants exercised included 699,883 of the Company’s
Class A warrants and 9,500 of the Company’s Class B warrants.  The
Class A warrants expired on July 2, 2007 and were exercisable at a price of
$10.00 per share (price adjusted for the reverse split effected on June 15,
2007).  In connection with the exercise of the warrants, the Company
incurred expenses including commissions to the placement agent of approximately
$250,000.  These private placements qualified for the exemptions from
registration under the Securities Act of 1933, as amended, (the “Act”) afforded
by Regulation S and Regulation D under the Act.  Of the total shares
sold, 678,085 were sold to offshore investors, and in connection therewith, the
Company claimed the exemption from registration provided by Regulation S of the
Act.  Of the total shares sold, 31,298 were sold to investors in the
United States, and in connection therewith, the Company claimed the exemption
from registration provided by Regulation D of the Act.  Directors and
senior management invested $71,337 for a total of 7,133 common
shares.
  19
 Table of Contents
  On
December 31, 2007, we sold shares of our common stock upon the exercise of
warrants.  We received gross proceeds of $8.6 million from the
exercise of warrants to acquire six-hundred ninety thousand, four-hundred ninety
(690,490) of the Company’s common shares.  The warrants were exercised
by 34 investors (30 non-U.S. investors and 4 U.S. investors).  The warrants
exercised were the Class B warrants which were exercisable at a price of $12.50
per share (price adjusted for the reverse split effected on June 15,
2007).  The Class B warrants had a notional expiration date of
December 29, 2007; however, since December 29, 2007 was a Saturday, the
effective expiration date was Monday, December 31, 2007. In connection with the
exercise of the warrants, the Company incurred expenses including commissions to
the placement agent of approximately $325,000.  Directors and senior
management invested $91,412 for a total of 7,313 common shares.
 
 Equity
Compensation Plan Information as of December 31, 2007
 
 The
following table represents options and warrants outstanding as of December 31,
2007:
  Plan
      Category
              
              Number of Shares to be
      Issued Upon Exercise of Outstanding Options, Warrants and
      Rights
              
              
              Weighted
      Average Exercise Price of Outstanding Options, Warrants and
      Rights
              
              
              Number
      of Shares Remaining Available for Future IssuanceOptions:Equity
      compensation plans approved by security holders
              
              
              812,844
              1
              
              $
              11.72
              
              
              
              608,866
              1Equity
      compensation plans not approved by security holders
              
              
              —
              
              
              
              —
              
              
              
              —Total
      Options
              
              
              812,844
              
              
              $
              11.72
              
              
              
              608,866Warrants:Equity
      compensation plans approved by shareholders
              
              
              —
              
              
              
              —
              
              
              
              —Equity
      compensation plans not approved by shareholders
              
              
              424,992
              
              
              $
              11.35
              
              
              
              —Total
      Warrants
              
              
              424,992
              
              
              $
              11.35
              
              
              
              —
 
 1Represents
awards issued under the 1994 Incentive Plan.  The maximum number of
awards allowed under the 1994 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 S&P 1500 Composite Specialty
Chemical Index since December 31, 2002, assuming a $100
investment.  The stock price performance shown on the graph below is
not necessarily indicative of future price performance.
  graph
  
 12/31/02
              
              
              12/31/03
              
              
              12/31/04
              
              
              12/31/05
              
              
              12/31/06
              
              
              12/31/07Clean
      Diesel Technologies, Inc.
              
              $
              100
              
              
              $
              190
              
              
              $
              113
              
              
              $
              68
              
              
              $
              120
              
              
              $
              307Russell
      2000 Index
              
              
              100
              
              
              
              145
              
              
              
              170
              
              
              
              176
              
              
              
              126
              
              
              
              200S&P
      1500 Composite Specialty Chemical Index
              
              
              100
              
              
              
              119
              
              
              
              135
              
              
              
              131
              
              
              
              157
              
              
              
              168
  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
2007, 2006 and 2005, and the Balance Sheet Data as of December 31, 2007 and 2006
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 31,2007
              
              
              2006
              
              
              2005
              
              
              2004
              
              
              2003(in
      thousands, except per share amounts)STATEMENTS
      OF OPERATIONS DATARevenue:Product
      sales
              
              $
              1,466
              
              
              $
              860
              
              
              $
              760
              
              
              $
              659
              
              
              $
              373License
      and royalty revenue
              
              
              3,459
              
              
              
              74
              
              
              
              47
              
              
              
              54
              
              
              
              194Consulting
      and other
              
              ─
              
              
              
              189
              
              
              
              5
              
              
              
              9
              
              
              ─Total
      revenue
              
              
              4,925
              
              
              
              1,123
              
              
              
              812
              
              
              
              722
              
              
              
              567Operating
      costs and expenses:Cost
      of total revenue
              
              
              1,126
              
              
              
              658
              
              
              
              471
              
              
              
              455
              
              
              
              219Selling,
      general and administrative
              
              
              8,041
              
              
              
              5,278
              
              
              
              4,963
              
              
              
              3,962
              
              
              
              2,695Research
      and development
              
              
              428
              
              
              
              510
              
              
              
              439
              
              
              
              506
              
              
              
              855Patent
      amortization and other expense
              
              
              364
              
              
              
              235
              
              
              
              170
              
              
              
              90
              
              
              
              58Loss
      from operations
              
              
              (5,034
              )
              
              
              (5,558
              )
              
              
              (5,231
              )
              
              
              (4,291
              )
              
              
              (3,260
              )Foreign
      currency exchange gain (loss)
              
              
              (11
              )
              
              
              104
              
              
              
              (221
              )
              
              
              101
              
              
              ─Interest
      income
              
              
              509
              
              
              
              58
              
              
              
              26
              
              
              
              47
              
              
              
              15Other
      income (expense), net
              
              
              1
              
              
              
              12
              
              
              ─
              
              
              ─
              
              
              ─Net
      loss
              
              $
              (4,535
              )
              
              $
              (5,384
              )
              
              $
              (5,426
              )
              
              $
              (4,143
              )
              
              $
              (3,245
              )Basic
      and diluted loss per common share
              
              $
              (0.66
              )
              
              $
              (1.03
              )
              
              $
              (1.48
              )
              
              $
              (1.29
              )
              
              $
              (1.28
              )Basic
      and diluted weighted-average shares outstanding
              
              
              6,886
              
              
              
              5,212
              
              
              
              3,678
              
              
              
              3,214
              
              
              
              2,544As
      of December 31,2007
              
              
              2006
              
              
              2005
              
              
              2004
              
              
              2003(in
      thousands)BALANCE
      SHEET DATACurrent
      assets
              
              $
              11,871
              
              
              $
              8,287
              
              
              $
              5,505
              
              
              $
              4,868
              
              
              $
              7,023Total
      assets
              
              
              24,663
              
              
              
              9,018
              
              
              
              6,274
              
              
              
              5,513
              
              
              
              7,441Current
      liabilities
              
              
              1,663
              
              
              
              1,070
              
              
              
              496
              
              
              
              391
              
              
              
              868Long-term
      liabilities
              
              ─
              
              
              ─
              
              
              ─
              
              
              ─
              
              
              ─Working
      capital
              
              
              10,208
              
              
              
              7,217
              
              
              
              5,009
              
              
              
              4,477
              
              
              
              6,155Stockholders’
      equity
              
              
              23,000
              
              
              
              7,948
              
              
              
              5,778
              
              
              
              5,122
              
              
              
              6,573
  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 use our innovative solutions and know-how to bring
these technologies to market through our licensees.
 
 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).  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 Environmental Protection Agency
(EPA) verified Platinum Plus Purifier System, our fuel-borne catalyst and
diesel-oxidation catalyst, and catalyzed wire mesh filters).  Our
Platinum Plus fuel-borne catalyst is registered with the EPA and other
environmental authorities around the world.  We received EPA
verification of our Purifier System (fuel-borne catalyst and diesel oxidation
catalyst) in October 2003 and a verification of our catalyzed wire mesh filter
system (fuel-borne catalyst and catalyzed wire mesh filter) in June
2004.  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.  Of our
operating revenue for the year ended December 31, 2005, approximately
93.6% was from product sales, 5.8% was from technology
licensing fees and royalties and 0.6% was from 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.
 
 Our
Platinum Plus fuel-borne catalyst concentrate and finished product are sold to
distributors, resellers and vehicle fleets in various industries, including
beverage, grocery, shipping, fuel delivery and marine, among other end
users.  We license our ARIS nitrogen oxides reduction system 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 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.  We acquired the rights to
proprietary technology for catalyzed wire mesh filters from Mitsui Co., Ltd. in
2005 and 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.
 
 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.  We
received EPA registration for our platinum–cerium fuel-borne catalyst (Platinum
Plus) in December 1999.  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 $49.5
million as of December 31, 2007.  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, salary and benefits, consulting fees, materials
and testing gear.
 
 Our
research and development expenses totaled approximately $428,000, $510,000 and
$439,000 for the years ended December 31, 2007, 2006 and 2005,
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, 2007, 2006 and 2005 was $41,000,
$44,000 and $53,000, 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, 2007 and 2006, the Company’s
patents, net were $817,000 and $603,000, respectively.
 
 Newly
Adopted Accounting Standards
 
 Effective
January 1, 2007, we adopted the provision of the Financial Accounting Standards
Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income
Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”).  FIN
48 clarifies the accounting for uncertainties in income taxes recognized in a
company’s financial statements in accordance with Statement of Financial
Accounting Standard (“SFAS”) No. 109 and prescribes a recognition threshold and
measurement attributable for financial disclosure of tax positions taken or
expected to be taken on a tax return.  In addition, FIN 48 provides
guidance on derecognition, classification, interest and penalties, accounting in
interim periods, disclosure and transition.  It is the Company’s
policy to classify in the financial statements accrued interest and penalties
attributable to a tax position as income taxes.  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.  The adoption of FIN
48 did not have a material impact on our financial position, results of
operations or cash flows.
 
 We file
our tax returns as prescribed by the tax laws of the jurisdictions in which we
operate.  Our tax years ranging from 2004 through 2007 remain open to
examination by various taxing jurisdictions as the statute of limitations has
not expired.
 
 Recent
Accounting Pronouncements
 
 In
September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.”  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,
this Statement 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.  The Company will
adopt SFAS No. 157 in the first quarter of 2008.  We are currently
evaluating the impact, if any, of SFAS No. 157 on the Company’s consolidated
financial statements.
  25
 Table of Contents
  In
February 2007, the FASB issued 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.  SFAS No. 159 is
effective for the Company’s first quarter of 2008.  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.  We are currently evaluating the impact, if
any, of SFAS No. 159 on the Company’s 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 is effective, on a prospective basis, for us
in the fiscal year beginning January 1, 2009.  The Company is currently
assessing the impact of SFAS No. 141R on its consolidated financial position and
results of operations.
 
 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.  SFAS No. 160 is effective, on a
prospective basis, for us in the fiscal year beginning January 1, 2009.
 However, presentation and disclosure requirements must be retrospectively
applied to comparative financial statements.  The Company is currently
assessing the impact of SFAS No. 160 on its consolidated financial position and
results of operations.
 
 Results
of Operations
 
 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.
  26
 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
              
              
              
              279Depreciation
      and all other
              
              
              117
              
              
              
              202Total
      selling, general and administrative expenses
              
              $
              8,041
              
              
              $
              5,278
 
 Compensation
and benefit expense for the year ended December 31, 2007 includes $1,967,000 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.
  27
 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.
 
 Year
Ended December 31, 2006 Compared to Year Ended December 31, 2005
 
 Revenue
was $1,123,000 in 2006 compared to $812,000 in 2005, an increase of $311,000, or
38.3%, reflecting increases in all of our revenue sources.  Operating
revenue for the year ended December 31, 2006 consisted of approximately 76.6% in
product sales, 6.6% in technology licensing fees and royalties and 16.8% in
consulting and other revenue.  Operating revenue for the year ended
December 31, 2005 consisted of approximately 93.6% in product sales, 5.8% in
technology licensing fees and royalties and 0.6% in consulting and other
revenue.
 
 Product
sales increased $100,000, or 13.2%, to $860,000 in 2006 from $760,000 in
2005.  Product sales include our Platinum Plus fuel-borne catalyst and
hardware and compared to 2005, reflect an $180,000, or 43.7%, increase in our
Platinum Plus fuel-borne catalyst sales offset by an $80,000, or 22.8%, decrease
in hardware sales.  The increase in product sales is primarily due to
higher demand for our Platinum Plus fuel-borne catalyst attributable to the
benefits of cleaner burning engines, along with improved fuel economy, sought by
end users and an increase in our ARIS advanced reagent injector and dosing
systems for selective catalytic reduction, partially offset by a decline in
installations of our Platinum Plus Purifier Systems.  License fees and
royalty revenue was $74,000 in 2006 compared to $47,000 in 2005, an increase of
$27,000, or 57.4%, primarily due to royalty payments related to our ARIS
technology.  Consulting and other revenue was $189,000 in 2006
compared to $5,000 in 2005, an increase of $184,000.  The increase in
consulting and other revenue is attributable to consulting services we performed
in 2006.  From time to time, we perform technical consulting services
on behalf of existing and prospective customers.
 
 Total
cost of revenue was $658,000 for the year ended December 31, 2006 compared to
$471,000 for the year ended December 31, 2005, an increase of $187,000, or
39.7%, attributable to higher costs and sales volume in 2006 compared to
2005.  Total gross profit as a percentage of revenue was 41.4% and
42.0% for the years ended December 31, 2006 and 2005, respectively.
 
 Our cost
of product sales in 2006 was $612,000 compared to $471,000 in 2005, an increase
of $141,000 attributable primarily to higher platinum costs included in our
fuel-borne catalyst and higher hardware installation costs.  Gross
margin for product sales in 2006 was $248,000, or 28.8% of product sales,
compared to $289,000 in 2005, or 38.0% of product sales, with the decline due to
the higher costs in 2006.  Our cost of license fee and royalty revenue
was zero resulting in $74,000 gross margin.  Our cost of other
revenue, consisting primarily of consultant labor and incremental travel-related
costs, was $46,000, resulting in consulting and other gross margin of
$143,000.
 
 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.
  28
 Table of Contents
  Selling,
general and administrative expenses were $5,278,000 for the year ended December
31, 2006 compared to $4,963,000 in 2005, an increase of $315,000, or
6.3%.  Selling, general and administrative expenses are summarized
below:
 
 (in
      thousands)Years
      ended December 31,2006
              
              
              2005Non-cash
      stock-based compensation
              
              $
              304
              
              
              $ Severance
              
              
              357
              
              
              Compensation
      and benefits
              
              
              2,400
              
              
              
              2,771Total
      compensation and benefits
              
              $
              3,061
              
              
              $
              2,771Professional
      services
              
              
              792
              
              
              
              834Travel
              
              
              538
              
              
              
              546Occupancy
              
              
              406
              
              
              
              475Sales
      and marketing expenses
              
              
              279
              
              
              
              161Depreciation
      and all other
              
              
              202
              
              
              
              176Total
      selling, general and administrative expenses
              
              $
              5,278
              
              
              $
              4,963
 
 Compensation
and benefit expense for the year ended December 31, 2006 includes $304,000 of
non-cash charges for the fair value of stock options granted in accordance with
SFAS No. 123R, which we adopted in January 2006.  Also included are
$357,000 of severance charges related to the departure of CDT’s former president
and chief operating officer who had been released from employment in January
2006.  In addition, compensation and benefit expense for the year
ended December 31, 2006 reflects a full year of employment of the
individual serving as our executive vice president, chief operations officer,
North America and chief technology officer, who was hired in August
2005.
 
 Professional
fees include public relations, investor relations and financial advisory
fees.  Occupancy costs include office rents, insurance and related
costs.  We increased our investment in sales and marketing in 2006
with the objective of laying the groundwork for sales growth and licensing of
our core technologies in 2007.
 
 Research
and development expenses were $510,000 for the year ended December 31, 2006
compared to $439,000 in 2005, an increase of $71,000, or 16.2%.  The
increase in research and development was primarily due to additional testing
costs incurred in the U.K.
 
 Patent
amortization and other patent costs increased to $235,000 in 2006 from $170,000
in 2005.  Included are $17,000 and $32,000 in 2006 and 2005,
respectively, related to abandonment of some patents.  Patent
amortization expense for the years ended December 31, 2006 and 2005 was $44,000
and $53,000, respectively.
 
 Interest
income was $58,000 for the year ended December 31, 2006 compared to $26,000 in
2005, an increase of $32,000 due to the higher average balance of invested funds
in 2006 because of private placement funding received at the end of
2005.
  29
 Table of Contents
  Liquidity and Capital
Resources
 
 Net cash
used for operating activities was $4.2 million for the year ended December 31,
2007 and was used primarily to fund the 2007 net loss of $4.5 million, adjusted
for non-cash items.  Included in the 2007 non-cash items was stock
option compensation expense of $2,208,000 accounted for in accordance with SFAS
No. 123R, which we adopted on January 1, 2006.
 
 Accounts
receivable, net increased to $1,927,000 at December 31, 2007 from $100,000 at
December 31, 2006 due to technology licensing fees and sales of our Purifier
System to meet the requirements of the London Low Emission
Zone.  Inventories, net increased to $1,093,000 at December 31, 2007
from $365,000 at December 31, 2006 due to the timing of our platinum metal
purchases and at a higher cost than the prior year.  In addition, we
are maintaining higher inventory balances for our international operations to
support fulfillment of orders placed to comply with the requirements of the
London Low Emission Zone.  Our accounts payable and accrued
expenses contributed $677,000 to our operating cash flow, reflecting higher
general business activities.
 
 We used
$19.3 million for investing activities in 2007, primarily for investments in
auction rate securities collateralized by student loans and substantially
guaranteed by the U.S. Department of Education.  We used $313,000 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 $19.7 million for the year ended December
31, 2007 and is attributable to exercise of warrants ($15.2 million, net of
expenses), collection of subscriptions from the 2006 private placement ($4.3
million, net) and exercise of options ($0.4 million).
 
 In the
December 2006 private placement, investors agreed to purchase 1.4 million shares
of our common stock and warrants for the right to acquire an additional 1.4
million shares of our common stock, for a total gross sales price of $9.5
million (proceeds, net of $410,000 in expenses, amounting to approximately $9.0
million), of which $4.3 million, net of expenses, was collected in 2007. 
As described in Note 6 of Notes to the Consolidated Financial Statements,
of the $4.3 million subscriptions receivable at December 31, 2006, $2.4 million,
net was classified in current assets and $1.9 million, net was classified as a
reduction of stockholders’ equity.
 
 In the
December 2006 private placement, each investment unit was sold for $6.75 and was
comprised of one share of our common stock, one Class A warrant and one Class B
warrant, each warrant entitling the holder to acquire one additional share of
common stock for every two shares purchased in the offering.  In the
aggregate, the warrants comprised approximately 0.7 million Class A warrants and
0.7 million Class B warrants.  The Class A warrants were exercisable
at a per share price of $10.00 and expired on July 2, 2007 (see
below).  The Class B warrants were exercisable at a per share price of
$12.50 and expired on December 29, 2007 (see below).
 
 We
received gross proceeds of $15.7 million from the exercise of Class A and B
warrants to acquire 1,399,873 shares of our common stock.  In
connection with the exercise of the warrants, we incurred expenses including
fees to the placement agent of approximately $575,000.  Proceeds from
the exercise of the Class A and B warrants, net of the placement agent fees,
totaled $15.2 million.  We are using the proceeds from this private
placement for general working capital purposes.
 
 In
connection with this private placement, we undertook to apply for the listing of
our outstanding shares on a recognized U.S. stock exchange at such time as we
should satisfy the applicable listing requirements.  On June 29, 2007,
we submitted an application for listing our common stock on The NASDAQ Capital
Market.  We were approved to be listed on The NASDAQ Capital Market on
September 27, 2007, and our common stock began trading on The NASDAQ Capital
Market effective October 3, 2007.  In conjunction therewith, we
incurred approximately $52,000 in costs which were charged to additional paid-in
capital, $50,000 of which was for the entry fee paid to NASDAQ.
 
 Also in
conjunction with this private placement, we undertook to file a registration
statement under the Securities Act of 1933 covering the shares of common stock
and the shares of common stock underlying the warrants following completion of
the audit of our financial statements for the year 2006.  On June 29,
2007, we filed a Registration Statement on Form S-1 with the SEC covering these
shares of common stock.  The costs associated with the filing of the
registration statement, including review by outside legal counsel and our
registered public accountants, SEC filing fees and miscellaneous charges totaled
approximately $83,000 and was charged to additional paid-in
capital.
  30
 Table of Contents
  Aggregate
stockholder-related charges to additional paid-in capital in 2007 were $168,000
and included the costs referred to in the two preceding
paragraphs along with approximately $33,000 incurred for services related
to our five-for-one reverse stock split.  The reverse split was
approved by our stockholders at the annual meeting held on June 7,
2007.  The reverse split became effective at the close of business on
June 15, 2007.
 
 At
December 31, 2007 and 2006, we had cash and cash equivalents of $1,517,000 and
$5,314,000, respectively, a decrease of $3,797,000 due to
investments.  Our working capital was $10.2 million at December 31,
2007 compared to $7.2 million at December 31, 2006, an increase of $3.0 million
primarily attributable to the increased short-term investments at December 31,
2007.  We have been primarily dependent upon funding from new and
existing stockholders during the last three years (see Note 6 of Notes to
Consolidated Financial Statements).
 
 Our
management believes that our available funds at December 31, 2007 will be
sufficient to sustain our operations at current levels through
2009.  These funds consist of available cash and investments and the
funding derived from our revenue sources.
 
 The
Company sold approximately $7.1 million of its investments in auction rate
securities subsequent to December 31, 2007. However, starting on February 15,
2008, 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
auction rate securities is typically provided by an auction process that resets
the applicable interest rate at pre-determined intervals.  These
failed auctions represent market risk exposure and are not defaults or credit
events.  Holders of the securities continue to receive interest on the
investment, currently at a pre-determined maximum rate, and the securities will
be auctioned every 28 days until the auction succeeds, the issuer calls the
securities, or they mature.  Accordingly, because there may be no
effective mechanism for selling these securities, the securities
may be viewed as long-term assets.  The funds associated with
failed auctions will not be accessible until a successful auction occurs or a
buyer is found outside of the auction process.  We classified $11.7
million of these auction rate securities as non-current investments as of
December 31, 2007.  At this time, the Company does not believe
such securities are impaired or that the failure of the auction mechanism will
have a material impact on the Company’s liquidity or financial
position.
 
 We have
incurred losses since inception aggregating $49.5 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.  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.
 
 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.
 
 We have
no indebtedness, nor any standby credit arrangements.
  31
 Table of Contents
  Capital
Expenditures
 
 As of
December 31, 2007, 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,
2007:
 
 (in
      thousands)2
      to 3
              
              
              4
      to 5
              
              
              Over
      5Total
              
              
              1 Year
              
              
              Years
              
              
              Years
              
              
              YearsOperating
      Leases
              
              $
              494
              
              
              $
              205
              
              
              $
              158
              
              
              $
              117
              
              
              $
              14Other
              
              
              355
              
              
              
              71
              
              
              
              142
              
              
              
              142
              
              
              ─Total
              
              $
              849
              
              
              $
              276
              
              
              $
              300
              
              
              $
              259
              
              
              $
              14
  The
operating leases include our facilities in the U.S. and U.K. and consist of
leases with the following original terms:  a five-year lease for our
executive offices, a four-year lease for warehouse space and a 64-month lease
for administrative offices.  Other represents our approximate costs
for legal services and certain administrative costs under a management services
agreement with Fuel Tech, which we expect to continue.
 
 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, 2007, 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—Capital Market Conditions” for discussion of factors relating to our
investments that may impact the Company.
 
 Our
transactions are primarily denominated in U.S. dollars.  We typically
make certain payments in various foreign currencies for salary expense, patent
annuities and maintenance, product tests and registration, local marketing and
promotion and consultants.
  32
 Table of Contents
  Item8.
              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, 2007
and 2006 and the related consolidated statements of operations, comprehensive
loss, changes in stockholders' equity and cash flows for each of the three years
in the period ended December 31, 2007. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
 
 We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the 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, 2007 and 2006 and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 2007 in conformity with
accounting principles generally accepted in the United States of
America.
 
 As
discussed in Note 2, effective January 1, 2006, the Company adopted
Statement of Financial Accounting Standards No. 123R, "Share-Based
Payment."
 
 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, 2007, based on criteria
established in Internal Control-Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission (“COSO”), and our report
dated March 11,
2008 expressed an unqualified opinion thereon.
  
 New York,
New York
 March 11,
2008
  33
 Table of Contents
  CLEAN
DIESEL TECHNOLOGIES, INC.
 Consolidated
Balance Sheets
 (in
thousands, except share data)
 
 December
      31,2007
              
              
              2006AssetsCurrent
      assets:Cash
      and cash equivalents
              
              $
              1,517
              
              
              $
              5,314Accounts
      receivable, net of allowance of $49 and $34, respectively
              
              
              1,927
              
              
              
              100Investments
              
              
              7,100
              
              
              ─Inventories,
      net
              
              
              1,093
              
              
              
              365Other
      current assets
              
              
              234
              
              
              
              96Subscriptions
      receivable, net
              
              ─
              
              
              
              2,412Total
      current assets
              
              
              11,871
              
              
              
              8,287Investments
              
              
              11,725
              
              
              ─Patents,
      net
              
              
              817
              
              
              
              603Fixed
      assets, net of accumulated depreciation of $421 and $350,
      respectively
              
              
              175
              
              
              
              91Other
      assets
              
              
              75
              
              
              
              37Total
      assets
              
              $
              24,663
              
              
              $
              9,018Liabilities
      and Stockholders’ EquityCurrent
      liabilities:Accounts
      payable
              
              $
              757
              
              
              $
              330Accrued
      expenses
              
              
              850
              
              
              
              740Customer
      deposits
              
              
              56
              
              
              ─Total
      current liabilities
              
              
              1,663
              
              
              
              1,070Commitments
      (Note 8)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 and 9,000,000
      shares, respectively; issued and outstanding 8,124,056 and 5,964,493
      shares, respectively
              
              81
              
              
              
              60subscribed
      and to be issued 667,998 shares at December 31, 2006
              
              ─
              
              
              
              7Additional
      paid-in capital,  net of subscriptions receivable of $1,901 at
      December 31, 2006
              
              
              72,447
              
              
              
              52,854Accumulated
      other comprehensive income (loss)
              
              
              (16
              )
              
              
              4Accumulated
      deficit
              
              
              (49,512
              )
              
              
              (44,977
              )Total
      stockholders’ equity
              
              
              23,000
              
              
              
              7,948Total
      liabilities and stockholders’ equity
              
              $
              24,663
              
              
              $
              9,018
 
 
 The
accompanying notes are an integral part of the consolidated financial
statements.
  34
 Table of Contents
 
 CLEAN
DIESEL TECHNOLOGIES, INC.
 Consolidated
Statements of Operations
 (in
thousands, except per share amounts)
 
 For
      the years ended December 31,Revenue:
              
              2007
              
              
              2006
              
              
              2005Product
      sales
              
              $
              1,466
              
              
              $
              860
              
              
              $
              760Technology
      licensing fees and royalties
              
              
              3,459
              
              
              
              74
              
              
              
              47Consulting
      and other
              
              ─
              
              
              
              189
              
              
              
              5Total
      revenue
              
              
              4,925
              
              
              
              1,123
              
              
              
              812Costs
      and expenses:Cost
      of revenue – product sales
              
              
              1,126
              
              
              
              612
              
              
              
              471Cost
      of revenue – licensing fees and royalties
              
              ─
              
              
              ─
              
              
              ─Cost
      of revenue – consulting and other
              
              ─
              
              
              
              46
              
              
              ─Selling,
      general and administrative
              
              
              8,041
              
              
              
              5,278
              
              
              
              4,963Research
      and development
              
              
              428
              
              
              
              510
              
              
              
              439Patent
      amortization and other expense
              
              
              364
              
              
              
              235
              
              
              
              170Operating
      costs and expenses
              
              
              9,959
              
              
              
              6,681
              
              
              
              6,043Loss
      from operations
              
              
              (5,034
              )
              
              
              (5,558
              )
              
              
              (5,231
              )Other
      income (expense):Foreign
      currency exchange gain (loss)
              
              
              (11
              )
              
              
              104
              
              
              
              (221
              )Interest
      income
              
              
              509
              
              
              
              58
              
              
              
              26Other
              
              
              1
              
              
              
              12
              
              
              ─Net
      loss
              
              $
              (4,535
              )
              
              $
              (5,384
              )
              
              $
              (5,426
              )Basic
      and diluted loss per common share
              
              $
              (0.66
              )
              
              $
              (1.03
              )
              
              $
              (1.48
              )Basic
      and diluted weighted-average number ofcommon
      shares outstanding
              
              
              6,886
              
              
              
              5,212
              
              
              
              3,678Consolidated
      Statements of Comprehensive Loss(in
      thousands)For the years ended December
      31,2007
              
              
              2006
              
              
              2005Net
      loss
              
              $
              (4,535
              )
              
              $
              (5,384
              )
              
              $
              (5,426
              )Other
      comprehensive income (loss):Foreign
      currency translation adjustment
              
              
              (20
              )
              
              
              4
              
              
              ─Comprehensive
      loss
              
              $
              (4,555
              )
              
              $
              (5,380
              )
              
              $
              (5,426
              )
   The
accompanying notes are an integral part of the consolidated financial
statements.
  35
 Table of Contents
 
 CLEAN
DIESEL TECHNOLOGIES, INC.
 Consolidated
Statements of Changes in Stockholders’ Equity
 (in
thousands)
 
 AccumulatedCommon
      Stock
              
              
              Additional
              
              
              Other
              
              
              
              
              
              TotalCommon
      Stock
              
              
              To
      be Issued
              
              
              Paid-in
              
              
              Comprehensive
              
              
              Accumulated
              
              
              Stockholders’Shares
              
              
              Amount
              
              
              Shares
              
              
              Amount
              
              
              Capital
              
              
              Income
      (Loss)
              
              
              Deficit
              
              
              EquityBalance
      at December 31, 2004
              
              
              3,433
              
              
              $
              34
              
              
              ─
              
              $
              ─
              
              
              $
              39,255
              
              
              $
              ─
              
              
              $
              (34,167
              )
              
              $
              5,122Net
      loss
              
              ─
              
              
              ─
              
              
              ─
              
              
              ─
              
              
              ─
              
              
              ─
              
              
              
              (5,426
              )
              
              
              (5,426
              )Options
      exercised
              
              ─
              
              
              ─
              
              
              ─
              
              
              ─
              
              
              
              2
              
              
              ─
              
              
              ─
              
              
              
              2Issuance
      of common stock
              
              
              1,635
              
              
              
              17
              
              
              ─
              
              
              ─
              
              
              
              5,505
              
              
              ─
              
              
              ─
              
              
              
              5,522Common
      stock subscribed and to be issued
              
              ─
              
              
              ─
              
              
              
              141
              
              
              
              1
              
              
              
              487
              
              
              ─
              
              
              ─
              
              
              
              488Payment
      of directors’ fees in common stock
              
              
              5
              
              
              ─
              
              
              ─
              
              
              ─
              
              
              
              70
              
              
              ─
              
              
              ─
              
              
              
              70Balance
      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 for stock options
              
              ─
              
              
              ─
              
              
              ─
              
              
              ─
              
              
              
              304
              
              
              ─
              
              
              ─
              
              
              
              304Issuance
      of common stock
              
              
              876
              
              
              
              9
              
              
              
              (141
              )
              
              
              (1
              )
              
              
              4,718
              
              
              ─
              
              
              ─
              
              
              
              4,726Common
      stock subscribed and to 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 in common 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 for stock options
              
              ─
              
              
              ─
              
              
              ─
              
              
              ─
              
              
              
              2,208
              
              
              ─
              
              
              ─
              
              
              
              2,208Issuance
      of common stock
              
              
              668
              
              
              
              7
              
              
              
              (668
              )
              
              
              (7
              )
              
              
              1,901
              
              
              ─
              
              
              ─
              
              
              
              1,901Foreign
      currency translation
              
              ─
              
              
              ─
              
              
              ─
              
              
              ─
              
              
              ─
              
              
              
              (20
              )
              
              ─
              
              
              
              (20
              )Expenses
      of registration and reverse split
              
              ─
              
              
              ─
              
              
              ─
              
              
              ─
              
              
              
              (168
              )
              
              ─
              
              
              ─
              
              
              
              (168
              )Payment
      of directors’ fees in common stock
              
              
              20
              
              
              ─
              
              
              ─
              
              
              ─
              
              
              
              140
              
              
              ─
              
              
              ─
              
              
              
              140Balance
      at December 31, 2007
              
              
              8,124
              
              
              $
              81
              
              
              ─
              
              
              $
              ─
              
              
              $
              72,447
              
              
              $
              (16
              )
              
              $
              (49,512
              )
              
              $
              23,000
 
 
 The
accompanying notes are an integral part of the consolidated financial
statements.
  36
 Table of Contents
  CLEAN
DIESEL TECHNOLOGIES, INC.
 Consolidated
Statements of Cash Flow
 (in
thousands)
 
 For
      the years ended December 31,2007
              
              
              2006
              
              
              2005Operating
      activitiesNet
      loss
              
              $
              (4,535
              )
              
              $
              (5,384
              )
              
              $
              (5,426
              )Adjustments
      to reconcile net loss to cash used in operating
activities:Depreciation
      and amortization
              
              
              112
              
              
              
              138
              
              
              
              163Provision
      for inventory
              
              
              22
              
              
              
              27
              
              
              
              43Provision
      for doubtful accounts, net
              
              
              28
              
              
              
              23
              
              
              
              12Compensation
      expense for stock options and warrants
              
              
              2,208
              
              
              
              304
              
              
              ─Loss
      on disposition/abandonment of fixed assets/patents
              
              
              58
              
              
              
              23
              
              
              
              33Changes
      in operating assets and liabilities:Accounts
      receivable
              
              
              (1,855
              )
              
              
              2
              
              
              
              7Inventories
              
              
              (750
              )
              
              
              (107
              )
              
              
              59Other
      current assets and other assets
              
              
              (177
              )
              
              
              (12
              )
              
              
              (23
              )Accounts
      payable and accrued expenses
              
              
              677
              
              
              
              678
              
              
              
              167Other
      liabilities
              
              
              56
              
              
              
              (9
              )
              
              
              9Net
      cash used for operating activities
              
              
              (4,156
              )
              
              
              (4,317
              )
              
              
              (4,956
              )Investing
      activitiesPurchase
      of investments
              
              
              (18,825
              )
              
              ─
              
              
              ─Patent
      costs
              
              
              (313
              )
              
              
              (94
              )
              
              
              (235
              )Purchase
      of fixed assets
              
              
              (154
              )
              
              
              (20
              )
              
              
              (85
              )Net
      cash used for investing activities
              
              
              (19,292
              )
              
              
              (114
              )
              
              
              (320
              )Financing
      activitiesProceeds
      from issuance of common stock, net
              
              
              4,313
              
              
              
              5,214
              
              
              
              5,522Proceeds
      from exercise of warrants
              
              
              15,173
              
              
              ─
              
              
              ─Proceeds
      from exercise of stock options
              
              
              353
              
              
              
              14
              
              
              
              2Stockholder-related
      charges
              
              
              (168
              )
              
              ─
              
              
              ─Net
      cash provided by financing activities
              
              
              19,671
              
              
              
              5,228
              
              
              
              5,524Effect
      of exchange rate changes on cash
              
              
              (20
              )
              
              
              4
              
              
              ─Net
      (decrease) increase in cash and cash equivalents
              
              $
              (3,797
              )
              
              $
              801
              
              
              $
              248Cash
      and cash equivalents at beginning of the year
              
              
              5,314
              
              
              
              4,513
              
              
              
              4,265Cash
      and cash equivalents at end of the year
              
              $
              1,517
              
              
              $
              5,314
              
              
              $
              4,513Supplemental
      non-cash activities:Common
      stock subscribed, net
              
              $
              ─
              
              
              $
              4,313
              
              
              $
              488Payment
      of accrued directors’ fees in common stock
              
              
              140
              
              
              
              94
              
              
              
              70
 
 
 The
accompanying notes are an integral part of the consolidated financial
statements.
  37
 Table of Contents
  CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
 
 1.
              Business
 
 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’s products include Platinum Plus, a fuel-borne
catalyst; the Purifier System, which combines its fuel-borne catalyst with a
diesel oxidation catalyst; the fuel-borne catalyst/catalyzed wire mesh filter
system; and the ARIS nitrogen oxides reduction system.  CDT is
establishing a network of licensed distributors to sell and market its patented
Platinum Plus fuel-borne catalyst, verified Purifier System and verified
fuel-borne catalyst/catalyzed wire mesh filter system.  CDT also
directly markets and sells the Platinum Plus fuel-borne catalyst, Purifier
System and catalyzed wire mesh filter systems to key corporate fleets to
generate demand for its technologies.  CDT’s strategy for the ARIS
nitrogen oxides reduction system is to license the patented technology to
engineering and automotive companies for an up-front license fee and an on-going
royalty.  The success of the Company’s technologies will depend upon
the commercialization opportunities of the technologies, governmental
regulations and corresponding requirements of foreign and state agencies to
drive demand.
 
 During
2007, 2006 and 2005, the Company incurred net losses of approximately $4.5
million, $5.4 million and $5.4 million, respectively, and at December 31, 2007,
has an accumulated deficit of approximately $49.5 million.  Net cash
used for operating activities for the year ended December 31, 2007 was
approximately $4.2 million.  As of December 31, 2007, the Company’s
cash and cash equivalents were $1.5 million, investments classified as current
were $7.1 million and working capital was $10.2 million.  Based upon
the Company’s operating and cash plan for 2008 which takes into consideration
the cash and investments at December 31, 2007, management believes that the
Company will have sufficient working capital to fund its operations through
December 31, 2008.
 
 2.
              Significant
      Accounting Policies
 
 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 6).
 
 Basis
of Presentation:
 
 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.
 
 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.
 
 Reclassifications:
 
 Some
amounts in prior years’ financial statements have been reclassified to conform
to the current year’s presentation.
  38
 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 U.S. Environmental Protection Agency (EPA) verified
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 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.  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.
  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.
  39
 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 December 31, 2007
and 2006, our inventory reserves were $22,000 and $27,000,
respectively.
 
 Fixed
Assets:
 
 Our fixed
assets, comprised of furniture and fixtures, purchased software 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
$71,000, $94,000 and $112,000 for the years ended December 31, 2007, 2006 and
2005, 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, 2007 and 2006, the Company’s
patents, net were $817,000 and $603,000, 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 income (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 $11,000 in
2007, a gain of $104,000 in 2006 and a loss of $221,000 in 2005.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 $(16,000) and $4,000 for the years ended December 31, 2007 and
2006, respectively, is included in accumulated other comprehensive income (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 income (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.
  40
 Table of Contents
  CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
 
 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
2007, 2006 and 2005 does not include common share equivalents associated with
812,800, 648,100 and 649,200 options, respectively, and 281,600, 1,557,400 and
101,300 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.
 
 Investments:
 
 Investments
represent auction rate securities which 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.  These
investments are classified as "available for sale" under the provisions of SFAS
No. 115, "Accounting for Certain Investments in Debt and Equity
Securities."  Liquidity for these auction-rate securities is typically
provided by an auction process that resets the applicable interest rate at
pre-determined intervals.  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 securities trade at
par and are callable at par on any interest payment date at the option of the
issuer.  Interest is paid at the end of each auction
period.  The investments are reported at cost, which approximates fair
value due to their variable interest rates.  Classification of marketable
securities 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.  If management intends to hold the securities
for longer than one year as of the balance sheet date, or, if the state of the
auction market effectively prevents their liquidation on resale, they are
classified as non-current.  All income generated from these
investments were recorded as interest income.  The contractual maturities
of the auction rate securities range from 2027 to
2047.Accrued interest receivable at December 31, 2007 was
approximately $49,000.  As of December 31, 2007, we had not
experienced any failure of the dutch auctions employed to reset interest rates
on these securities.
 
 The Company sold approximately $7.1
million in auction rate securities subsequent to December 31, 2007. 
However, starting on February 15, 2008, the Company experienced difficulty in
selling additional securities because of the failure of the auction
mechanism as a result of sell orders exceeding buy
orders.  Liquidity for these auction rate securities is typically
provided by an auction process that resets the applicable interest rate at
pre-determined intervals.  These failed auctions represent market risk
exposure and are not defaults or credit events.  Holders of the
securities continue to receive interest on the investment, currently at a
pre-determined maximum rate, and the securities will be auctioned every 28 days
until the auction succeeds, the issuer calls the securities, or they
mature.  Accordingly, because there may be no effective mechanism for
selling these securities, the securities may be viewed as long-term
assets.  The funds associated with failed auctions will not be
accessible until a successful auction occurs or a buyer is found outside of the
auction process.  We classified $11.7 million of these auction rate
securities as non-current investments as of December 31,
2007.  At this time, the Company does not believe such securities are
impaired or that the failure of the auction mechanism will have a material
impact on the Company’s liquidity or financial position.
  41
 Table of Contents
  CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
 
 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 have not experienced any losses on such
accounts and 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, 2007, 2006 and 2005, 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 31,2007
              
              
              2006
              
              
              2005Customer
      A
              
              
              30.5
              %
              
              
              *
              
              
              
              *Customer
      B
              
              
              24.3
              %
              
              
              *
              
              
              
              *Customer
      C
              
              
              15.5
              %
              
              
              *
              
              
              
              *Customer
      D
              
              
              *
              
              
              
              29
              %
              
              
              11
              %Customer
      E
              
              
              *
              
              
              
              13
              %
              
              
              12
              %Customer
      F
              
              
              *
              
              
              
              *
              
              
              
              24
              %Customer
      G
              
              
              *
              
              
              
              *
              
              
              
              10
              %
 
 *
              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.
 
 In
addition, at December 31, 2007, one customer represented 57% of the Company’s
gross accounts receivable balance (Customer A).  In addition, at
December 31, 2006, the Company had two customers that represented 46% of its
gross accounts receivable balance (Customers D and G).
 
 Fair Value of Financial
Instruments:
 
 Our
financial instruments consist of cash and cash equivalents, short-term
investments, accounts receivable, accounts payable and accrued
expenses.  At December 31, 2007 and 2006, the fair value of these
instruments approximated their carrying value (carried at cost).
 
 Stock-Based
Compensation:
 
 Effective
January 1, 2006, the Company adopted SFAS No. 123 (Revised 2004), “Share Based
Payment,” which 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.  SFAS No. 123R supersedes the
Company’s previous accounting under SFAS No. 123, “Accounting for Stock-Based
Compensation,” which permitted the Company to account for such compensation
under Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock
Issued to Employees.”  In accordance with APB No. 25 and related
interpretations, no compensation cost had been recognized in connection with the
issuance of stock options, as all options granted under the Company’s stock
option plan had an exercise price equal to or greater than the market value of
the underlying common stock on the date of the grant.
  42
 Table of Contents
  CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
 
 The
Company applied the modified prospective transition method upon adoption of SFAS
No. 123R under which compensation cost was required to be recorded as earned for
all unvested stock options outstanding at the beginning of the first year of
adoption of SFAS No. 123R based upon the grant date fair value estimated in
accordance with the original provisions of SFAS No. 123 and for compensation
cost for all share-based payments granted or modified subsequently based on fair
value estimated in accordance with the provisions of SFAS No.
123R.  The Company’s financial statements as of and for the years
ended December 31, 2007 and 2006 reflect the impact of SFAS No. 123R but, in
accordance with the modified prospective transition method, the Company’s
financial statements for prior periods have not been restated to reflect, and do
not include, the impact of SFAS No. 123R.
 
 For the
year ended December 31, 2007, share-based compensation for options and warrants
attributable to employees, officers, directors and outside consultants was
$2,208,000, or $0.32 per share, and has been included in the Company’s 2007
consolidated statement of operations.  For the year ended December 31,
2006, share-based compensation for options attributable to employees, officers
and directors was $304,000, or $0.06 per share, and was included in the
Company’s 2006 consolidated statement of operations.  Compensation
costs for stock options which vest over time are recognized over the vesting
period.  As of December 31, 2007, the Company had $1,740,000 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.
 
 In March
2005, the Company’s board of directors accelerated the vesting of certain then
outstanding, unvested stock options comprising 72,600 options with fair value of
$498,000.  That action was taken to avoid compensation charges under
SFAS No. 123R.  Because the market price of the Company’s common stock
at the time of the acceleration of vesting was below the option exercise price,
no additional expense was recognized in the Company’s 2005 consolidated
statement of operations.
 
 If
compensation expense had been determined based on the fair value at the date of
grant for awards under the stock option plan, consistent with SFAS No. 123, as
amended, the Company’s pro forma net loss and pro forma basic and diluted loss
per common share would have been as follows:
 
 (in
      thousands, except per share amounts)Year
      ended December 31,2005Net
      loss attributable to common stock holders as reported
              
              $
              (5,426
              )Add:
      Stock-based compensation expense included in reported net loss, net of
      related tax effects
              
              
              ─Deduct:
      Total stock-based employee compensation expense determined under fair
      value-based method for all awards,
                net of related tax effects
              
              
              (875
              )Pro
      forma net loss attributable to common stockholders
              
              $
              (6,301
              )Net
      loss per share attributable to common stockholders:Basic
      and diluted net loss per common share - as reported
              
              $
              (1.48
              )Basic
      and diluted per common share - pro forma
              
              $
              (1.71
              )
 
 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, salary and benefits, consulting fees, materials
and testing gear.
  43
 Table of Contents
  CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
 
 Selling,
General and Administrative Expenses:
 
 Selling,
general and administrative expenses are comprised of the following:
 
 (in
      thousands)Years
      ended December 31,2007
              
              
              2006
              
              
              2005Non-cash
      stock-based compensation
              
              $
              1,966
              
              
              $
              304
              
              
              $
              Severance
              
              
              
              
              
              357
              
              
              Compensation
      and benefits
              
              
              2,997
              
              
              
              2,400
              
              
              
              2,771Total
      compensation and benefits
              
              $
              4,963
              
              
              $
              3,061
              
              
              $
              2,771Professional
      services
              
              
              1,487
              
              
              
              792
              
              
              
              834Travel
              
              
              622
              
              
              
              538
              
              
              
              546Occupancy
              
              
              511
              
              
              
              406
              
              
              
              475Sales
      and marketing expenses
              
              
              341
              
              
              
              279
              
              
              
              161Depreciation
      and all other
              
              
              117
              
              
              
              202
              
              
              
              176Total
      selling, general andadministrative
      expenses
              
              $
              8,041
              
              
              $
              5,278
              
              
              $
              4,963
 
 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.
 
 Newly
Adopted Accounting Standards:
 
 Effective
January 1, 2007, we adopted the provision of the FASB Interpretation No. 48,
“Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement
No. 109” (“FIN 48”).  FIN 48 clarifies the accounting for
uncertainties in income taxes recognized in a company’s financial statements in
accordance with SFAS No. 109 and prescribes a recognition threshold and
measurement attributable for financial disclosure of tax positions taken or
expected to be taken on a tax return.  In addition, FIN 48 provides
guidance on derecognition, classification, interest and penalties, accounting in
interim periods, disclosure and transition.  It is the Company’s
policy to classify in the financial statements accrued interest and penalties
attributable to a tax position as income taxes.  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.  The adoption of FIN
48 did not have a material impact on our financial position, results of
operations or cash flows.
 
 We file
our tax returns as prescribed by the tax laws of the jurisdictions in which we
operate.  Our tax years ranging from 2004 through 2007 remain open to
examination by various taxing jurisdictions as the statute of limitations has
not expired.
 
 Recent
Accounting Pronouncements:
 
 In
September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.”  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,
this Statement 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.  The Company will
adopt SFAS No. 157 in the first quarter of 2008.  We are currently
evaluating the impact, if any, of SFAS No. 157 on the Company’s consolidated
financial statements.
  44
 Table of Contents
  CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
 
 
 In
February 2007, the FASB issued 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.  SFAS No. 159 is
effective for the Company’s first quarter of 2008.  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.  We are currently evaluating the impact, if
any, of SFAS No. 159 on the Company’s 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 is effective, on a prospective basis, for us
in the fiscal year beginning January 1, 2009.  The Company is currently
assessing the impact of SFAS No. 141R on its consolidated financial position and
results of operations.
 
 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.  SFAS No. 160 is effective, on a
prospective basis, for us in the fiscal year beginning January 1, 2009.
 However, presentation and disclosure requirements must be retrospectively
applied to comparative financial statements.  The Company is currently
assessing the impact of SFAS No. 160 on its consolidated financial position and
results of operations.
 
 3.
              Inventories
 
 Inventories
are comprised of the following:
 
 (in
      thousands)December
      31,2007
              
              
              2006Finished
      Platinum Plus fuel-borne catalyst
              
              $
              165
              
              
              $
              144Platinum
      concentrate/metal
              
              
              656
              
              
              
              103Hardware
              
              
              260
              
              
              
              119Other
              
              
              34
              
              
              
              26$
              1,115
              
              
              $
              392Less:
      inventory reserves
              
              
              (22
              )
              
              
              (27
              )Inventories,
      net
              
              $
              1,093
              
              
              $
              365
 
 4.
              Patents
 
 Patents
held by the Company consist of capitalized patent costs net of accumulated
amortization and are as follows:
 
 (in
      thousands)December
      31,2007
              
              
              2006Patents
              
              $
              975
              
              
              $
              742Less:
      accumulated amortization
              
              
              (158
              )
              
              
              (139
              )Patents,
      net
              
              $
              817
              
              
              $
              603
  45
 Table of Contents
  CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
 
 Patent
amortization expense for the years ended December 31, 2007, 2006 and 2005 was
$41,000, $44,000 and $53,000, respectively.  Patent amortization
expense for each of the five succeeding years based upon patents as of December
31, 2007 is estimated to be approximately $40,000 annually.
 
 5.
              Accrued
      Expenses
 
 Accrued
expenses are comprised of the following:
 
 (in
      thousands)December
      31,2007
              
              
              2006Accrued
      placement agent fees
              
              
              $
              ─
              
              
              $
              410Professional
      fees
              
              
              
              264
              
              
              
              64Accrued
      compensation
              
              
              
              254
              
              
              
              122Accrued
      directors’ and technical advisory board fees
              
              
              
              44
              
              
              
              144Accrual
      for inventory received
              
              
              
              106
              
              
              ─Value
      added taxes payable
              
              
              
              98
              
              
              ─Travel
      and all other
              
              
              
              84
              
              
              ─Accrued
      expenses
              
              
              $
              850
              
              
              $
              740
 
 6.
              Stockholders’
      Equity
 
 Authorized
Capital Stock
 
 As of
December 31, 2007, 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 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
determinedbased 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.
  46
 Table of Contents
  CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
 
 Issuance
of Common Shares
 
 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
7).  The proceeds from the exercise of warrants will be 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 and June 2005, the Company issued 12,438 and 5,435
shares of its common stock, respectively, to non-executive members of its board
of directors in lieu of approximately $94,000 and $70,000 of directors’ fees
earned for services provided during the years ended December 31, 2005 and 2004,
respectively.  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 7).  The material terms of the
agreements between the Company and the investors were as follows:
  47
 Table of Contents
  CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
 
 
 (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;
 
 (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
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 (see Note 7 – Warrants).
 
 During
2005, Clean Diesel received proceeds of $5.5 million (net of $232,000 in
expenses) through a private placement of 1.635 million shares of its common
stock.  The price of the common stock was £2.00 (GBP) per share
(approximately $3.52 per share).  In addition, Clean Diesel received
subscriptions for an additional $487,500 (net of $12,500 in expenses) related to
the above transaction for 0.141 million shares of its common stock of which all
$487,500 was received by March 3, 2006.
 
 7.
              Stock
      Options and Warrants
 
 Stock
Options
 
 The
Company maintains an equity award plan approved by its stockholders, the 1994
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 that will ultimately vest.  The
estimate is based on the Company’s historical rates of
forfeitures.  Share-based compensation expense recognized by the
Company in 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.  The share-based compensation
expense is based on awards ultimately expected to vest.  In the
Company’s pro forma information required under SFAS No. 123 for the periods
prior to 2006 (see Note 2), the Company accounted for forfeitures as they
occurred.  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.
  48
 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, 2007, 2006 and 2005 were $11.65, $7.47 and $4.30,
respectively, and were estimated using the Black-Scholes option pricing model
with the following weighted-average assumptions:
 
 Years
      ended December 31,2007
              
              
              2006
              
              
              2005Expected
      term in years
              
              
              8.75
              
              
              
              8.64
              
              
              
              4.0Risk-free
      interest rate
              
              
              2.38
              %
              
              
              4.56
              %
              
              
              4.2
              %Expected
      volatility
              
              
              97.5
              %
              
              
              104.7
              %
              
              
              106.9
              %Dividend
      yield
              
              
              0
              %
              
              
              0
              %
              
              
              0
              %
 
 The
following table summarizes the Company’s stock option activity and related
information for the years ended December 31:
 
 2007
              
              
              2006
              
              
              2005Shares
              
              
              WeightedAverageExercisePrice
              
              
              Shares
              
              
              WeightedAverageExercisePrice
              
              
              Shares
              
              
              WeightedAverageExercisePriceOutstanding
      at beginning of year
              
              
              648,087
              
              
              $
              10.08
              
              
              
              649,187
              
              
              $
              10.305
              
              
              
              533,677
              
              
              $
              11.97Options
      granted
              
              
              291,166
              
              
              $
              14.565
              
              
              
              21,000
              
              
              $
              8.315
              
              
              
              134,800
              
              
              $
              5.725Options
      exercised
              
              
              (93,609
              )
              
              $
              7.553
              
              
              
              (3,000
              )
              
              $
              4.50
              
              
              
              (400
              )
              
              $
              4.50Options
      expired
              
              
              (20,333
              )
              
              $
              23.018
              
              
              
              (9,667
              )
              
              $
              23.08
              
              
              
              (8,000
              )
              
              $
              11.73Options
      forfeited
              
              
              (12,467
              )
              
              $
              6.169
              
              
              
              (9,433
              )
              
              $
              9.995
              
              
              
              (10,890
              )
              
              $
              34.10Outstanding
      at end of year
              
              
              812,844
              
              
              $
              11.716
              
              
              
              648,087
              
              
              $
              10.08
              
              
              
              649,187
              
              
              $
              10.305Options
      exercisable at year-end
              
              
              657,177
              
              
              $
              11.205
              
              
              
              597,931
              
              
              $
              10.41
              
              
              
              566,987
              
              
              $
              10.93Options
      available for grant atyear-end
              
              
              608,866
              
              
              
              
              
              
              
              144,853
              
              
              
              
              
              
              ─Weighted-average
      fair value ofoptions
      granted during the year
              
              
              
              
              
              $
              11.645
              
              
              
              
              
              
              $
              7.465
              
              
              
              
              
              
              $
              4.30Aggregate
      intrinsic value –options
      exercised
              
              
              
              
              
              $
              880,974
              
              
              
              
              
              
              $
              3,000
              
              
              
              
              
              
              $
              200Aggregate
      intrinsic value –options
      outstanding
              
              
              
              
              
              $
              9,172,231Aggregate
      intrinsic value –options
      exercisable
              
              
              
              
              
              $
              7,751,592
  49
 Table of Contents
  CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
 
 The
following table summarizes information about stock options outstanding at
December 31, 2007:
 
 Options
      Outstanding
              
              
              Options
      ExercisableRange
      of Exercise Prices
              
              
              Number
                Outstanding
              
              
              Weighted
      Average Remaining ContractualLife(In
      Years)
              
              
              Weighted Average
                Exercise Price
              
              
              Number
                Exercisable
              
              
              Weighted Average
                Exercise Price$3.60 – $7.875
              
              
              
              123,867
              
              
              
              6.35
              
              
              $
              5.58
              
              
              
              113,867
              
              
              $
              5.46$8.25
      – $9.10
              
              
              
              191,911
              
              
              
              8.07
              
              
              $
              8.79
              
              
              
              124,577
              
              
              $
              8.65$9.20 – $10.125
              
              
              
              152,200
              
              
              
              5.46
              
              
              $
              9.68
              
              
              
              152,200
              
              
              $
              9.68$11.40
      – $16.50
              
              
              
              191,366
              
              
              
              4.25
              
              
              $
              14.30
              
              
              
              186,366
              
              
              $
              14.26$19.125
      – $23.125
              
              
              
              153.500
              
              
              
              9.97
              
              
              $
              19.13
              
              
              
              80,167
              
              
              $
              19.13$3.60 – $23.125
              
              
              
              812,844
              
              
              
              6.78
              
              
              $
              11.716
              
              
              
              657,177
              
              
              $
              11.205
 
 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
outlined in Note 6, 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.
  50
 Table of Contents
  CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
 
 Warrant
activity for the years ended December 31 is summarized as follows:
 
 2007
              
              
              2006
              
              
              2005Shares
              
              
              Weighted
      Average Exercise Price
              
              
              Shares
              
              
              Weighted
      Average Exercise Price
              
              
              Shares
              
              
              Weighted
      Average Exercise PriceOutstanding
      at beginning of year
              
              
              1,557,424
              
              
              $
              10.98
              
              
              
              101,346
              
              
              $
              8.835
              
              
              
              106,346
              
              
              $
              9.125Warrants
      to be issued
              
              143,432
              
              
              $
              14.09
              
              
              
              1,466,400
              
              
              $
              11.125
              
              
              ─
              
              
              $
              ─Warrants
      issued
              
              
              124,142
              
              
              $
              11.67
              
              
              ─
              
              
              $
              ─
              
              
              ─
              
              
              $
              ─Warrants
      exercised
              
              
              (1,399,873
              )
              
              $
              11.25
              
              
              ─
              
              
              $
              ─
              
              
              ─
              
              
              $
              ─Warrants
      expired / forfeited
              
              
              (133
              )
              
              $
              7.71
              
              
              
              (10,322
              )
              
              $
              10.00
              
              
              
              (5,000
              )
              
              $
              15.00Outstanding
      and to be issuedat
      end of year
              
              
              424,992
              
              
              $
              11.35
              
              
              
              1,557,424
              
              
              $
              10.98
              
              
              
              101,346
              
              
              $
              8.835Warrants
      exercisable at year-end
              
              
              424,992
              
              
              $
              11.35
              
              
              
              1,557,424
              
              
              $
              10.98
              
              
              
              101,346
              
              
              $
              8.835Aggregate
      intrinsic value
              
              
              
              
              
              $
              4,953,662
              
              
              
              
              
              
              $
              102,325
 
 The
following table summarizes information about warrants outstanding as of December
31, 2007:
 
 Warrants
      Outstanding and ExercisableRange
      of Exercise Prices
              
              
              NumberOutstandingAnd Exercisable
              
              
              Weighted
      Average Remaining Contractual Life(In
      Years)
              
              
              Weighted
      Average Exercise Price$7.50
      – $8.15
              
              
              
              63,053
              
              
              
              4.54
              
              
              $
              7.97$8.438
              
              
              
              140,542
              
              
              
              4.00
              
              
              $
              8.44$10.00
      - $16.45
              
              
              
              221,397
              
              
              
              4.53
              
              
              $
              14.15424,992
              
              
              
              4.35
              
              
              $
              11.35
 
 8.
              Commitments
 
 The
Company is obligated under a five-year sublease agreement through March 2009 for
its principal office (3,925 square feet) at an annual cost of approximately
$128,000, including rent, utilities and parking.  The Company is
obligated under a four-year lease through July 2008 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, 2007, 2006 and 2005, rental
expense approximated $205,000, $181,000 and $162,000,
respectively.  Our contractual obligations for each of the next five
years ended December 31 are as follows: $276,000, $167,000, $133,000, $130,000
and $129,000; and $14,000 thereafter.
 
 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 expires in 2008.  CDT may
terminate the royalty obligation to Fuel Tech by payment of $1.1 million in
2008.  CDT, as assignee and owner, maintains the technology at its
expense.  Royalty expense incurred under this obligation in 2007, 2006
and 2005 amounted to $14,300, $14,500 and $10,300,
respectively.  Royalties payable to Fuel Tech at December 31, 2007 and
2006 were $14,300 and $14,500, respectively.
  51
 Table of Contents
  CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
 
 9.
              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.  Currently, and 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 $71,000, $70,000 and
$71,000 for the years ended December 31, 2007, 2006 and 2005,
respectively.  The Company believes the charges under this Management
and Services Agreement are reasonable and fair.  The Management and
Services Agreement is for an indefinite term but may be cancelled by either
party by notifying the other in writing of the cancellation on or before May 15
in any year.
 
 As
outlined in Note 6, we issued 19,599, 12,438 and 5,435 shares of our common
stock in 2007, 2006 and 2005, respectively, to non-executive members of our
board of directors in lieu of approximately $25,000, $115,000, $94,000 and
$70,000 of directors’ fees earned in the first quarter of 2007 and the years
ended December 31, 2006, 2005 and 2004, 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 6), 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.
 
 10.
              Technology
      Licensing Agreements and Other
Revenue
 
 In 2007,
we executed license agreements with new licensees and amended a license
agreement with an existing licensee 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
license will stay in effect for the remaining life of the underlying
patents.  The licenses are non-exclusive and cover specific geographic
territories.  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 nonexclusive
license.
 
 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.
 
 11.
              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.
 
 At
December 31, 2007, the Company had tax losses available for offset against
future years’ taxable income of approximately $40.6 million, expiring between
2009 and 2027.  At December 31, 2007, the Company had research and
development tax credit carryforwards of approximately $1.7 million, expiring
between 2011 and 2027.  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 $1.7 million
during the year ended December 31, 2007.  Deferred tax assets and
valuation allowance at December 31, 2007 and 2006 are as follows:
  52
 Table of Contents
  CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
 
 (in
      thousands)December
      31,2007
              
              
              2006Research
      and development
              
              $
              1,746
              
              
              $
              1,680Net
      operating loss carryforwards
              
              
              16,229
              
              
              
              14,991Options
              
              
              531
              
              
              
              122Deferred
      tax assets
              
              
              18,506
              
              
              
              16,793Less:
      valuation allowance
              
              
              (18,506
              )
              
              
              (16,793
              )Deferred
      tax assets, net
              
              $
              
              
              
              $
              
 
 Effective
January 1, 2007, we adopted FIN 48.  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.
 
 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 $734,500.  Utilization of CDT's U.S. federal tax loss
carryforwards for the period after December 12, 1995 and before December 30,
2006 is limited as a result of the ownership change in excess of 50%
attributable to the private placement which was effective December 29, 2006 to a
maximum annual allowance of $2,518,985.   Utilization of CDT's tax
losses subsequent to 2006 may be limited due to cumulative ownership changes in
any future three-year period.  It is not anticipated that CDT's U.S.
taxable income for the full calendar year 2007 will be in excess of the limited
allowable loss carryforwards.
 
 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, 2007, 2006 and 2005 are as follows:
 
 Years
      ended December 31,2007
              
              
              2006
              
              
              2005Income
      taxes (benefits) at statutory rates
              
              
              (34
              %)
              
              
              (34
              %)
              
              
              (34
              %)Change
      in valuation allowance
              
              
              34
              %
              
              
              34
              %
              
              
              34
              %Income
      taxes (benefits)
              
              
              %
              
              
              %
              
              
              %
 
 12.
              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 31,2007
              
              
              2006
              
              
              2005U.S.
              
              $
              2,563
              
              
              $
              684
              
              
              $
              675Europe
              
              
              2,255
              
              
              
              117
              
              
              
              48Asia
              
              
              107
              
              
              
              322
              
              
              
              89Total
      revenue
              
              $
              4,925
              
              
              $
              1,123
              
              
              $
              812
  53
 Table of Contents
  CLEAN
DIESEL TECHNOLOGIES, INC.
 Notes
to Consolidated Financial Statements
 
 The
Company has patent coverage in North and South America, Europe, Asia, Africa and
Australia.  As of December 31, 2007 and 2006, the Company’s assets
comprise the following:
 
 (in
      thousands)December
      31,2007
              
              
              2006U.S.
              
              $
              22,680
              
              
              $
              8,494Foreign
              
              
              1,983
              
              
              
              524Total
      assets
              
              $
              24,663
              
              
              $
              9,018
 
 13.
              Subsequent
      Events
 
 In
January 2008, we issued 12,594 shares of our common stock upon the exercise of
21,666 stock options and received approximately $19,000 in cash and the
surrender of 9,072 options.
 
 14.
              Quarterly
      Financial Data (unaudited)
 
 The table
below presents the Company’s unaudited quarterly information for the last eight
quarters.
  (in
      thousands, except per share amounts)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
      income (loss) attributable to common stockholders
                
                
                (1,815
                )
                
                
                (519
                )
                
                
                651
                
                
                
                (2,852
                )Basic
      and diluted net income (loss) per common share
                
                
                (0.30
                )
                
                
                (0.08
                )
                
                
                0.09
                
                
                
                (0.38
                )Three Months Ended2006
                
                March 31
                
                
                June 30
                
                
                September 30
                
                
                December 31Total
      revenue
                
                $
                269
                
                
                $
                279
                
                
                $
                339
                
                
                $
                236Gross
      profit *
                
                
                153
                
                
                
                123
                
                
                
                133
                
                
                
                56Net
      loss attributable to common stockholders
                
                
                (1,584
                )
                
                
                (1,190
                )
                
                
                (1,114
                )
                
                
                (1,496
                )Basic
      and diluted net loss per common share
                
                
                (0.31
                )
                
                
                (0.23
                )
                
                
                (0.21
                )
                
                
                (0.30
                )
 *  Gross
profit is defined as total revenue less total cost of revenue.
  54
 Table of Contents
  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, 2007.
 
 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, 2007, 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.
  55
 Table of Contents
  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.
 
 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, 2007, 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 December 31, 2007 and 2006, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 2007, and our report dated March
11, 2008 expressed an unqualified opinion thereon.
  
 New York,
New York
 March 11,
2008
 
 
 (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.  During our fourth fiscal quarter of
2007, we commenced transferring certain of our financial processing systems to
new software.  In connection with the software implementation and resulting
business process changes, we continue to enhance the design and documentation of
our internal control processes to ensure suitable controls over our financial
reporting.
 
 Except as
described above, 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 2007.
 
 Item9B.
              Other
      Information
 
 None.
  56
 Table of Contents
  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 2008 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 2008
annual meeting of stockholders and is incorporated by reference.
 
 Item12.
              Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholders 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 2008 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 2008 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 2008 annual meeting of stockholders and is
incorporated by reference.
  57
 Table of Contents
  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
 
 Balance
Sheets as of December 31, 2007 and 2006
 
 Statements
of Operations and Comprehensive Loss for the years ended December 31, 2007, 2006
and 2005
 
 Statements
of Changes in Stockholders’ Equity for the years ended
December 31, 2007, 2006 and 2005
 
 Statements
of Cash Flows for the years ended December 31, 2007, 2006 and 2005
 
 (2)
              Financial
      Statement Schedules
 
 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
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 December 20, 2005 (incorporated by reference to Exhibit
      3(ii) to Annual Report on Form 10-K filed on March 30,
    2007).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 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).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).
  58
 Table of Contents
 
 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)
              
              1994
      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 December 31, 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).10(r)
              
              Form
      of Commitment Letter by and between the Company and Non-U.S. Purchasers of
      Units consisting of shares of common stock and warrants (incorporated by
      reference to Exhibit 10.1 to Form 8-K dated as of December 29,
      2006).
  59
 Table of Contents
 
 10(s)
              
              Form
      of Commitment Letter by and between the Company and U.S. Purchasers of
      Units consisting of shares of common stock and warrants (incorporated by
      reference to Exhibit 10.1 to Form 8-K dated as of December 29,
      2006).#10(t)
              
              Employment
      Agreement dated as of January 1, 2008 between Bernhard Steiner
      and the Company.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.
  60
 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 17, 2008
              
              By:
              /s/
              Bernhard SteinerDate
              
              
              
              Bernhard
      SteinerChief
      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/ Bernhard Steiner
              
              Chief
      Executive Officer, President and DirectorBernhard Steiner
              
              (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
 
 
 Dated:  March
17, 2008
   61