For the quarterly period ended September 30, 2012

or

For the transition period from                      to                    

Commission File Number: 001-33710

CLEAN DIESEL TECHNOLOGIES, INC.

(Exact name of registrant as specified in its charter)

4567 Telephone Road, Suite 100
                          Ventura, CA  93003                     

(Address of principal executive offices) (Zip Code)

Registrant’s telephone number, including area code:  (805) 639-9458

(Former name, former address and former fiscal year, if changed since last report)

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  þ No  o 

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

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

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

As of November 7, 2012, the outstanding number of shares of the registrant’s common stock, par value $0.01 per share, was 7,231,315.

CLEAN DIESEL TECHNOLOGIES, INC.

TABLE OF CONTENTS

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Table of Contents

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

As used in this Quarterly Report on Form 10-Q, the terms “the Company,” “we,” “us,” and “our” refer to Clean Diesel Technologies, Inc. and its consolidated subsidiaries.

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, adopted pursuant to the Private Securities Litigation Reform Act of 1995.  Forward-looking statements involve risks and uncertainties, as well as assumptions, which could cause our results to differ materially from those expressed or implied by such forward-looking statements. Forward-looking statements generally are identified by the words “may,” “will,” “project,” “might,” “expects,” “anticipates,” “believes,” “intends,” “estimates,” “should,” “could,” “would,” “strategy,” “plan,” “continue,” “pursue,” or the negative of these words or other words or expressions of similar meaning. All statements, other than statements of historical fact, are statements that could be deemed forward-looking statements. These forward-looking statements are based on information available to us, are current only as of the date on which the statements are made, 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. For a discussion of such risks and uncertainties, please see the discussion under the caption “Risk Factors” contained in our Annual Report on Form 10-K for the year ended December 31, 2011 filed with the Securities and Exchange Commission (the “SEC”) on March 29, 2012, including without limitation the following:

You should not place undue reliance on any forward-looking statements. 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. If we do update one or more forward-looking statements, no inference should be drawn that we will make additional updates with respect to other forward-looking statements.

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CLEAN DIESEL TECHNOLOGIES, INC.

Condensed Consolidated Statements of Operations and Comprehensive Loss

(In thousands, except per share amounts)

(Unaudited)

2

CLEAN DIESEL TECHNOLOGIES, INC.

Condensed Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)

CLEAN DIESEL TECHNOLOGIES, INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

1.    Organization

a .    Description of Business

Clean Diesel Technologies, Inc. (the “Company”) is a global manufacturer and distributor of heavy duty diesel and light duty vehicle emissions control systems and products to major automakers and retrofitters. Its business is driven by increasingly stringent global emission standards for internal combustion engines, which are major sources of a variety of harmful pollutants. The Company has operations in the United States, Canada, the United Kingdom, France, Japan and Sweden as well as an Asian investment.

    b.         Liquidity

Historically, the revenue we have generated has not been sufficient to fund our operating requirements and debt servicing needs. Notably, the Company has suffered recurring losses and negative cash flows from operations since inception, resulting in an accumulated deficit of $171.8 million at September 30, 2012. The Company has historically funded its operations through equity sales, debt and bank borrowings.

The Company has a $7.5 million secured demand facility backed by its receivables and inventory with Faunus Group International, Inc. (“FGI”). At September 30, 2012, the Company had $5.1 million in borrowings outstanding under this facility with $2.4 million available, subject to the availability of eligible accounts receivable and inventory balances for collateral.

The Company also has a purchase agreement with Lincoln Park Capital (“LPC”), under which the Company has the right, in its sole discretion, over a 30-month period to sell up to $10.0 million in common stock to LPC in amounts of up to $0.5 million to up to $1.5 million per sale, depending on certain conditions as set forth in the purchase agreement. Assuming a purchase price of $2.81 per share (the closing sale price of the Company’s common stock on September 30, 2012) and the purchase by LPC of the full 1,702,836 currently registered purchase shares, proceeds to the Company would be $4.8 million. There have been no sales to date under this arrangement.  

On May 15, 2012, the Company filed a shelf registration statement on Form S-3 with the SEC (the “Shelf Registration”) which was declared effective by the SEC on May 21, 2012. The Shelf Registration permits the Company to sell, from time to time, up to an aggregate of $50.0 million of various securities. See Note 8.

On July 27, 2012, the Company entered into a Loan Commitment Letter with Kanis S.A. pursuant to which the Company issued a promissory note in the principal amount of $3.0 million. The promissory note bears interest at 8% per annum which is payable quarterly in arrears and matures on July 27, 2015. See Note 7 for a detailed description of the promissory note.

At September 30, 2012, the Company had $7.6 million in cash and cash equivalents. Due to the proceeds from the note issued in July 2012 and availability under the secured demand facility with FGI and the purchase agreement with LPC, management believes that the Company will have access to sufficient working capital to sustain operations through at least the next twelve months. However, there is no assurance that, if necessary, the Company will be able to raise additional capital or reduce discretionary spending to provide the required liquidity.

2.       Summary of Significant Accounting Policies

    a.     Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) for interim financial reporting. In the opinion of management, all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation have been reflected. The results reported in these condensed consolidated financial statements should not necessarily be taken as indicative of results that may be expected for the entire year. Certain financial information that is normally included in annual financial statements prepared in accordance with U.S. generally accepted accounting principles, but is not required for interim reporting purposes, has been condensed or omitted. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in Clean Diesel Technologies, Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2011.

CLEAN DIESEL TECHNOLOGIES, INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

b.        Principles of Consolidation

The condensed consolidated financial statements include the financial statements of the Company and its wholly owned subsidiaries. Intercompany transactions and balances have been eliminated in consolidation.

c.        Use of Estimates

 The preparation of financial statements in conformity with accounting principles generally accepted in the United States (“U.S. GAAP”) requires management of the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

d.       Concentration of Risk

For the periods presented below, certain customers accounted for 10% or more of the Company’s revenue as follows:

Customer A is an automotive original equipment manufacturer ("OEM") and relates to sales within the Catalyst segment. Customers B and C are diesel system distributors within the HDD Systems segment.

For the periods presented below, certain customers accounted for 10% or more of the Company’s accounts receivable balance as follows:

Customer A above is an automotive OEM, customers B and C are diesel system distributors and customer D is a diesel systems installer.

For the periods presented below, certain vendors accounted for 10% or more of the Company’s raw material purchases as follows:

e.      Net Loss per Share

Basic net loss per share is computed using the weighted average number of common shares outstanding during the period. Diluted net loss per share is computed using the weighted average number of common shares and dilutive potential common shares. Dilutive potential common shares include employee stock options and restricted share units (“RSUs”) and other warrants and debt that are convertible into the Company’s common stock.

Diluted net loss per share excludes certain dilutive potential common shares outstanding as their effect is anti-dilutive. Because the Company incurred net losses in the three and nine months ended September 30, 2012 and 2011, the effect of potentially dilutive securities has been excluded in the computation of net loss per share and net loss from continuing operations per share as their impact would be anti-dilutive. Potential common stock equivalents excluded consist of the following (in thousands):

f.      Fair Value Measurements

Fair value is defined as an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset and liability. As a basis for considering such assumptions, a fair value hierarchy has been established that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1 measurement) and the lowest priority to unobservable inputs (level 3 measurements). The three levels of the fair value hierarchy are as follows:

• Level 1: Quoted prices (unadjusted) in active markets for identical assets or liabilities;
• Level 2: Inputs other than quoted prices included within Level 1 that are either directly or indirectly observable including quoted prices for similar instruments in active markets and quoted prices for identical or similar instruments in markets that are not active; and
• Level 3: Unobservable inputs in which little or no market activity exists, therefore requiring an entity to develop its own assumptions about the assumptions that market participants would use in pricing.

The fair values of the Company’s cash and cash equivalents, trade accounts receivable, prepaid expenses and other current assets, accounts payable and accrued expenses and other current liabilities approximate carrying values due to the short maturity of these instruments. The fair value of borrowings under the line of credit approximates their carrying value due to their variable interest rates. The fair value of shareholder notes payable, current is approximately $4.6 million and shareholder notes payable, noncurrent is $2.7 million at September 30, 2012 based on estimated rates currently available to the Company. The carrying amount of the Company’s capital lease obligations approximates the fair value. See Note 9 regarding the fair value of the Company’s warrants.

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g.     Accounting Changes

In May 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and International Financial Reporting Standards (“IFRS”).” This pronouncement was issued to provide a consistent definition of fair value and ensure that the fair value measurement and disclosure requirements are similar between U.S. GAAP and IFRS. ASU 2011-04 changes certain fair value measurement principles and enhances the disclosure requirements particularly for Level 3 fair value measurements. This pronouncement is effective for reporting periods beginning after December 15, 2011. The guidance concerns disclosure only and adoption did not have an impact on our financial position or results of operations.

In June 2011, the FASB issued ASU No. 2011-05, “Presentation of Comprehensive Income” which was issued to enhance comparability between entities that report under U.S. GAAP and IFRS, and to provide a more consistent method of presenting non-owner transactions that affect an entity’s equity. ASU 2011-05 eliminates the option to report other comprehensive income and its components in the statement of changes in stockholders’ equity and requires an entity to present the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement or in two separate but consecutive statements. This pronouncement is effective for reporting periods beginning after December 15, 2011 and full retrospective application is required. The guidance concerns disclosure only and adoption did not have an impact on our financial position or results of operations.

3.    Inventories

Inventories consist of the following (in thousands):

4.     Goodwill and Intangible Assets

Goodwill

The Company’s Engine Control Systems reporting unit, which is within its Heavy Duty Diesel Systems reporting segment, contains all of the Company’s allocated goodwill. The changes in the carrying amount of goodwill for the nine months ended September 30, 2012 are as follows (in thousands):

Intangible Assets

Intangible assets consist of the following (in thousands):

The Company recorded amortization expense related to amortizable intangible assets of $0.2 million during each of the three months ended September 30, 2012 and 2011.  The Company recorded amortization expense related to amortizable intangible assets of $0.5 million and $0.7 million during the nine months ended September 30, 2012 and 2011, respectively.

Estimated amortization expense for existing intangible assets for each of the next five years is as follows (in thousands):

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CLEAN DIESEL TECHNOLOGIES, INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

5.     Accrued Expenses and Other Current Liabilities

Accrued expenses and other current liabilities consist of the following (in thousands):

On May 2, 2011, the Company entered into an agreement with Tanaka Kikinzoku Kogyo K.K. ("TKK"), its investment partner in the Asia Pacific region, to provide equipment, engineering and support services to assist in TKK’s establishment of manufacturing operations in China under a joint venture between TKK and a Chinese entity for the purpose of manufacturing and selling diesel and automotive exhaust emission products in the China market. The Company received an up-front payment of $0.6 million which was included in deferred revenue at December 31, 2011. In September 2012, the Company and TKK entered into an amendment to the agreement reducing the scope of services under the contract resulting in a change in the total value of the contract from $1.5 million to $1.0 million.  

The Company accounted for this contract under ASC 605-35, “Revenue Recognition – Construction-type and Production-type Contracts” under the completed-contract method. As of September 30, 2012, the Company has completed its obligations under the agreement, as amended. As such, the Company has recognized $1.0 million in revenue, including the $0.6 million previously deferred, and $0.3 million in cost of revenues in the three and nine months ended September 30, 2012.

6.     Accrued Warranty

Changes in the Company’s product warranty reserve are as follows (in thousands):

7.     Debt

Long-term debt consists of the following (in thousands):

CLEAN DIESEL TECHNOLOGIES, INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Line of Credit with FGI

On February 14, 2011, the Company and certain of its subsidiaries (the “Credit Subsidiaries”) entered into Sale and Security Agreements with FGI to provide for a $7.5 million secured demand facility backed by its receivables and inventory (the “FGI Facility”). The Company and the Credit Subsidiaries also entered into guarantees to guarantee the performance of their obligations under the Sale and Security Agreements. The Company also granted FGI a first lien collateral interest in substantially all of its assets. On August 15, 2012, the Company and FGI agreed to amend the FGI Facility. As amended, the initial term was extended from February 14, 2013 to August 15, 2015 and may be extended at the Company’s option for additional one-year terms.

Under the FGI Facility, as amended, FGI can elect to purchase eligible accounts receivables from the Company and the Credit Subsidiaries at up to 80% of the value of such receivables (retaining a 20% reserve). Purchased receivables are subject to full recourse to the Company in the event of nonpayment by the customer. FGI becomes responsible for the servicing and administration of the accounts receivable purchased. The Company is not obligated to offer accounts in any month and FGI has the right to decline to purchase any accounts. At FGI’s election, FGI may advance the Company up to 80% of the value of any purchased accounts receivable, subject to the $7.5 million limit. Reserves retained by FGI on any purchased receivable are expected to be refunded to the Company net of interest and fees on advances once the receivables are collected from customers. The Company may also borrow against eligible inventory up to the inventory sublimit as determined by FGI subject to the aggregate $7.5 million limit under the FGI Facility and certain other conditions. Pursuant to the amendment, the inventory sublimit amount was increased from $1.0 million to the lesser of $2.0 million or 50% of the aggregate purchase price paid for accounts receivable purchased under the FGI facility.

The interest rate on advances or borrowings under the FGI Facility was reduced from the greater of (i) 7.50% per annum and (ii) 2.50% per annum above the Wall Street Journal “prime rate” to the greater of (i) 6.50% per annum and  (ii) 2.50% per annum above the prime rate, as defined. Any advances or borrowings under the FGI Facility are due on demand. The Company also agreed to pay FGI collateral management fees. As amended, the monthly collateral fees were reduced from 0.44% to 0.30% per month on the face amount of eligible receivables as to which advances have been made and from 0.55% to 0.38% per month on borrowings against inventory, if any. At any time outstanding advances or borrowings under the FGI Facility are less than $2.4 million, the Company agreed to pay FGI standby fees of (i) the interest rate on the difference between $2.4 million and the average outstanding amounts and (ii) 0.44% per month on 80% of the amount by which advances or borrowings are less than the agreed $2.4 million minimum.

The Company paid FGI a one-time facility fee of $75,000 upon entry into the FGI Facility and $75,000 upon amending the FGI facility. Also, if the Company terminates the FGI facility prior to the last day of the initial term, as extended, or any additional term, it must pay a termination fee of 2% of the facility limit then in effect. No termination fee will be due if the Company notifies FGI of its intent to terminate within 10 days of FGI increasing the reserve percentage for accounts to greater than 40% for more than 30 consecutive days. FGI may terminate the facility at any time. As such, the facility and amendment fees were expensed when incurred. The termination fee is not payable upon a termination by FGI or upon non-renewal.

The Company accounts for the sale of accounts receivable under the FGI Facility as a secured borrowing with a pledge of the subject receivables as collateral in accordance with ASC 860, “Transfers and Servicing.” At September 30, 2012, the Company had $4.5 million of gross accounts receivable pledged to FGI as collateral for short-term debt in the amount of $3.5 million. At September 30, 2012, the Company also had $1.6 million in borrowings outstanding against eligible inventory. The Company was in compliance with the terms of the FGI Facility at September 30, 2012.

6% Shareholder Note Due 2013

On December 30, 2010, the Company executed a Loan Commitment Letter with Kanis S.A., a shareholder of the Company, pursuant to which Kanis S.A. loaned the Company $1.5 million. The loan bears interest on the unpaid principal at a rate of 6%, with interest only payable quarterly in arrears, commencing March 31, 2011. The loan matures on June 30, 2013. In addition to principal and accrued interest, the Company is obligated to pay Kanis S.A. at maturity a “Payment Premium” ranging from $0.1 million to $0.2 million based proportionally on the number of days that the loan remains outstanding. There is no prepayment penalty. The loan is unsecured. In connection with the loan, the Company issued Kanis S.A. warrants to acquire 25,000 shares of its common stock at $10.40 per share. The relative estimated fair value of such warrants represents a discount from the face amount of the loan and has been recorded as a discount from the loan amount. The discount is being amortized using the effective interest method over the term of the loan.

8% Subordinated Convertible Shareholder Notes Due 2016

On April 11, 2011, the Company entered into a Subordinated Convertible Notes Commitment Letter with Kanis S.A. that provides for the sale and issuance by the Company of 8% subordinated convertible notes (the “Notes”). As provided in the Commitment Letter, on May 6, 2011 Kanis S.A. purchased from the Company at par $3.0 million aggregate principal amount of the Notes, which bear interest at a rate of 8% per annum, payable quarterly in arrears.

The Notes have a stated maturity of five years from the date of issuance. The original agreement allowed for the acceleration of the maturity of the Notes if: (i) the Company was in breach of the notes or other agreements with Kanis S.A., or (ii) Kanis S.A. provided written notice, not less than 30 days prior to such date, that it elected to accelerate the maturity to a date not earlier than November 11, 2012. On February 16, 2012, the Company and Kanis S.A. agreed to amend the terms of the Notes to modify the early redemption date from November 11, 2012 to May 12, 2013. The Notes also provide that the Company has the option to redeem the Notes at any time at a price equal to 100% of the face amount plus accrued and unpaid interest through the date of redemption. There is no prepayment penalty. The Notes are unsecured obligations of the Company and subordinated to existing and future secured indebtedness of the Company.

On July 27, 2012, the Company and Kanis S.A. further amended the terms of the Notes to modify the conversion feature. As amended, the outstanding principal balance of, and accrued and unpaid interest on, the Notes are convertible, at the option of Kanis S.A. at any time upon written notice given not less than 75 calendar days prior to the date of conversion, into no more than 250,000 shares of the Company’s common stock at a conversion price of $4.00 per share.

In connection with the February 16, 2012 amendment, the Company issued to Kanis S.A. warrants to acquire 5,000 shares of its common stock at $3.80 per share. The warrants are exercisable on or after August 16, 2014 and expire on the earlier of (x) August 16, 2017 and (y) that date that is 30 days after the Company gives notice to the warrant holder that the market value of one share of its common stock has exceeded 130% of the exercise price of the warrant for 10 consecutive days, which 10 consecutive days commence on or after August 16, 2014. The Company did not receive any cash consideration for the issuance of the warrants. The Company relied on the private placement exemption provided by Regulation S.

8% Shareholder Note Due 2015

On July 27, 2012, the Company executed a Loan Commitment Letter with Kanis S.A., pursuant to which the Company issued a promissory note in the principal amount of $3.0 million, which bears interest at 8% per annum, payable quarterly in arrears. The promissory note matures on July 27, 2015. There is no prepayment penalty or premium. The promissory note is unsecured. In connection with promissory note, the Company issued Kanis S.A. a warrant to acquire 45,000 shares of its common stock at $2.09 per share, a third of which become exercisable on the issuance date and each of the first and second anniversaries of the issuance date. This warrant expires on July 27, 2018. The Company did not receive any cash consideration for the issuance of this warrant, which was issued in reliance upon the private placement exemption provided by Regulation S. The relative estimated fair value of such warrant represents a discount from the face amount of the loan and has been recorded as a discount from the loan amount. The discount is being amortized using the effective interest method over the term of the loan.

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8.     Stockholders’ Equity

On May 23, 2012, the Company amended its Restated Certificate of Incorporation to increase the number of authorized shares of common stock to 24 million shares. At September 30, 2012, the Company had 24.1 million shares authorized, 24 million of which are $0.01 par value common stock and 100,000 of which are $0.01 par value preferred stock.

On May 15, 2012, the Company filed a Shelf Registration which was declared effective by the SEC on May 21, 2012. The Shelf Registration permits the Company to sell, from time to time, up to an aggregate of $50.0 million of various securities, including common stock, preferred stock, warrants to purchase common stock or preferred stock and units consisting of one or more shares of common stock, shares of preferred stock, warrants, or any combination of such securities. The Shelf Registration is intended to provide the Company with additional flexibility to access capital markets for general corporate purposes, subject to market conditions and the Company's capital needs.

On October 7, 2011, the Company signed a Purchase Agreement with LPC, together with a Registration Rights Agreement, whereby LPC agreed to purchase up to $10.0 million of the Company’s common stock over a 30-month period. Pursuant to the Registration Rights Agreement, the Company filed a registration statement on Form S-1 with the SEC on October 13, 2011 covering 1,823,577 shares that have been issued or may be issued to LPC under the Purchase Agreement. Of the shares registered, 40,247 shares were issued to LPC as a commitment fee upon entering into the Purchase Agreement; 80,494 shares may be issued to LPC pro rata as an additional commitment fee as up to $10.0 million of our common stock is purchased by LPC; and 1,702,836 represent shares that the Company may sell to LPC under the Purchase Agreement. The registration statement related to the transaction was declared effective by the SEC on December 5, 2011. Accordingly, the Company has the right, in its sole discretion, over a 30-month period to sell shares of its common stock to LPC in amounts of up to $0.5 million to up to $1.5 million per sale, depending on certain conditions as set forth in the Purchase Agreement, up to the aggregate amount of $10.0 million. There have been no sales to date under this arrangement.

There are no upper limits to the price LPC may pay to purchase the Company’s common stock and the purchase price of the shares related to the $10.0 million of future funding will be based on the prevailing market prices of the Company’s shares preceding the time of sales as computed in accordance with the Purchase Agreement without any fixed discount, with the Company controlling the timing and amount of future sales, if any, of shares to LPC. The purchase price per share is equal to the lesser of the lowest sales price of our common stock on the purchase date or the average of the three lowest closing sales prices of our common stock during the twelve consecutive business days prior to the date of the purchase by LPC.

LPC has agreed not to cause or engage in any manner whatsoever, any direct or indirect short selling or hedging of the Company’s shares of common stock. The fair value of the 40,247 shares issued as the initial commitment fee of $0.1 million is recorded as a deferred charge in other assets in the accompanying balance sheet at September 30, 2012 and will be amortized into equity over the usage of the equity line. The Company may terminate the Purchase Agreement at any time at its discretion without any cost or penalty. Any proceeds received by the Company under the Purchase Agreement are expected to be used for working capital and general corporate purposes.

9.    Warrants

Warrant activity for the nine months ended September 30, 2012 and warrant information as of September 30, 2012 is summarized as follows:  

Warrant Liability

The Company evaluates warrants on issuance and at each reporting date to determine proper classification as equity or as a liability. The Company has 379,678 outstanding warrants issued to former CSI Class A shareholders in connection with the business combination between Clean Diesel Technologies, Inc. (“CDTI”) and Catalytic Solutions, Inc. (“CSI”) on October 15, 2010 (the “Merger”) that it is required to physically settle by delivering registered shares. In addition, while the relevant warrant agreement does not require cash settlement if the Company fails to maintain registration of the warrant shares, it does not specifically preclude cash settlement. Accordingly, the Company’s agreement to deliver registered shares without express terms for settlement in the absence of continuous effective registration is presumed to create a liability to settle these warrants in cash, requiring liability classification. The contracts for the remaining warrants allow for settlement in unregistered shares and do not contain any other characteristics that would result in liability classification. Accordingly, these instruments have been classified in stockholders’ equity in the accompanying condensed consolidated balance sheets and are only valued on the issuance date and not subsequently revalued. The Company evaluated the balance sheet classification of all warrants at September 30, 2012 and noted no changes.

The liability-classified warrants are considered Level 3 in the fair value hierarchy because they are valued based on unobservable inputs. The Company determined the fair value of its liability-classified warrants using a Monte Carlo simulation model, which utilizes multiple input variables to estimate the probability that market conditions will be achieved. The assumptions used in the Monte Carlo simulation model were as follows:

Due to the significant change in the Company following the Merger, CDTI’s historical price volatility was not considered representative of expected volatility going forward. Therefore, the Company utilized an estimate based upon a weighted average of implied and historical volatility of a portfolio of peer companies and CDTI’s historical volatility.

The liability is remeasured at the end of each reporting period with changes in fair value recognized in other income (expense) in the consolidated statements of operations and comprehensive loss. The following is a reconciliation of the warrant liability measured at fair value using Level 3 inputs (in thousands):

10.    Share Based Payment

The Clean Diesel Technologies, Inc. Stock Incentive Plan (formerly known as the Clean Diesel Technologies, Inc. 1994 Incentive Plan), as amended (the “Plan”), provided for the awarding of incentive stock options, non-qualified stock options, stock appreciation rights, restricted shares, performance awards, bonuses or other forms of share-based awards or cash, or combinations of these to the Company’s directors, officers, employees, consultants and advisors (except consultants or advisors in capital-raising transactions) as the board of directors may determine. At the Company’s Annual Meeting of Shareholders held on May 23, 2012, the Company’s shareholders approved certain amendments to the Plan, the most significant of which changed the plan name, removed the evergreen provision and established a maximum number of 1.4 million shares to be reserved for issuance under the Plan, disallowed the repricing of outstanding stock options without shareholder approval, removed the ability to issue cash bonus awards under the Plan and modified the change in control provisions within the Plan. The Plan is more fully described in Note 13 to the Consolidated Financial Statements in the Company’s 2011 Annual Report on Form 10-K.

Stock-based compensation expense for both employee and non-employee awards is as follows (in thousands):

On March 8, 2012, the Compensation and Nominating Committee of the Company’s Board of Directors (the “Compensation Committee”) approved the grant of nonqualified stock options and RSUs to the Company’s newly-appointed Chief Executive Officer and President in reliance on the employment inducement exception to the NASDAQ rules that require shareholder approval of equity-based incentive plans and awards. The Company granted 176,676 nonqualified stock options at an exercise price of $2.83 per share. These options have a ten-year term, and vest 28% on the first anniversary of the date of grant and 9% quarterly thereafter. The Company also granted 58,892 RSUs at a fair value of $2.83 per unit. These RSUs vest 28% on the first anniversary of the date of grant and 9% quarterly thereafter, beginning June 20, 2013.

During the nine months ended September 30, 2012, the Compensation Committee approved the grant of long-term incentive awards to other employees consisting of nonqualified stock options and RSUs. The Company granted a total of 330,219 nonqualified stock options at a weighted average exercise price of $2.97 per share, a third of which vest on February 22, 2013 (the “Initial Vesting Date”) and each of the first and second anniversaries of the Initial Vesting Date. The Company also issued 113,255 RSUs at a weighted average fair value of $2.95 per unit, a third of which generally vest on March 20, 2013 (the “Vesting Commencement Date”) and each of the first and second anniversaries of the Vesting Commencement Date.

Stock Options

Stock option activity for the nine months ended September 30, 2012 and stock option information as of September 30, 2012 is summarized as follows:

The aggregate intrinsic value represents the difference between the exercise price and the Company’s closing stock price on the last trading day of the quarter.

The Company estimates the fair value of stock options using a Black-Scholes valuation model. The weighted-average fair value and assumptions used for the nine months ended September 30, 2012 and 2011 were as follows:

The expected term of the options has historically been based upon the historical term until exercise or expiration of all granted options. Due to the significant change in the Company following the Merger and significant change in the terms of the options granted, CDTI’s historical exercise data was not considered to provide a reasonable basis for estimating the expected term for current option grants. As such, the expected term of stock options granted in 2012 and 2011 was determined using the “simplified method” as allowed under ASC 718-10-S99. The “simplified method” calculates the expected term as the average of the vesting term and original contractual term of the options. Also, due to the significant change in the Company following the Merger, CDTI’s historical price volatility was not considered representative of expected volatility going forward. Therefore, the Company utilized an estimate based upon the historical and implied volatility of a portfolio of peer companies. 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. The dividend yield is assumed as 0% because the Company has not paid dividends and does not expect to pay dividends in the future.

Compensation costs for stock options that vest over time are recognized over the vesting period on a straight-line basis. As of September 30, 2012, the Company had $0.8 million of unrecognized compensation cost related to stock option grants that remained to be recognized over vesting periods. These costs are expected to be recognized over a weighted average period of 2.4 years.

There was no cash received from option exercises under any share-based payment arrangements for the nine months ended September 30, 2012 or 2011.

Restricted Share Units

RSU activity for the nine months ended September 30, 2012 and RSU information as of September 30, 2012 is as follows:

As of September 30, 2012, the Company had approximately $0.4 million of unrecognized compensation expense, net of estimated forfeitures, related to RSUs, which will be recognized over a weighted average estimated remaining life of 2.3 years.

11.     Contingencies

 Legal Proceedings

On September 30, 2008, Applied Utility Systems, Inc. (“AUS”), a former subsidiary of the Company, filed a complaint against Benz Air Engineering, Inc. (“Benz Air”). The Company sold the majority of the assets of AUS to Johnson Matthey (“JM”) on October 1, 2009; however, this lawsuit was excluded from the sale. The complaint was amended on January 16, 2009, and asserted claims against Benz Air for breach of contract, common counts and slander. AUS was seeking $0.2 million in damages, plus interest, costs and applicable penalties. In response to the complaint, Benz Air filed a cross-complaint on November 17, 2008, which named both AUS and the Company as defendants. The cross-complaint asserted claims against AUS and the Company for breach of oral contract, breach of express warranty, breach of implied warranty, negligent misrepresentation and intentional misrepresentation and was seeking not less than $0.3 million in damages, plus interest, costs and punitive damages. The trial was concluded on July 29, 2011 with the jury awarding AUS $0.2 million plus interest as well as an additional $0.3 million for false statements. On October 18, 2011, the trial court granted Benz Air’s motion and overturned the jury’s verdict regarding the $0.3 million for false statements, and denied Benz Air’s motion to overturn the jury’s verdict on the remaining counts. In addition, the trial court awarded the Company over $0.5 million in attorney’s fees. In the fourth quarter of 2011, the Company recorded a gain of $0.2 million related to a partial recovery of the award from the Benz Air litigation. On July 31, 2012, the Company and Benz Air completed a global settlement agreement that provides for a cash payment by Benz Air of $175,000, plus three individual payments of $25,000 each to be paid on October 1, 2012, January 2, 2013, and April 1, 2013. On September 25, 2012, the Company received all three remaining cash payments from Benz Air and recorded a gain which is presented in discontinued operations in the accompanying condensed consolidated statement of operations.  As a result, the Company has dismissed its lawsuit in this matter.

On April 30, 2010, CDTI received a complaint from the Hartford, Connecticut office of the U.S. Department of Labor (“U.S. DOL”) under Section 806 of the Corporate and Criminal Fraud Accountability Act of 2001, Title VIII of the Sarbanes-Oxley Act of 2002, alleging that a former employee had been subject to discriminatory employment practices. CDTI’s Board of Directors terminated the employee’s employment on April 19, 2010. The complainant in this proceeding does not demand specific relief. However, the statute provides that a prevailing employee shall be entitled to all relief necessary to make the employee whole, including compensatory damages, which may be reinstatement, back pay with interest, front pay, and special damages such as attorney’s and expert witness fees. CDTI responded on June 14, 2010, denying the allegations of the complaint. On March 29, 2011, the U.S. DOL investigator assigned to this matter requested information and documentation regarding the former employee’s allegations and the Company provided responsive documents as requested.  The Company also responded to additional requests from the U.S. DOL regarding electronic correspondence.  On October 6, 2011, the U.S. DOL investigator requested that the Company provide additional information and requested interviews with certain individuals.  The Company responded to those requests. On April 16, 2012, the U.S. DOL requested that the Company take part in non-binding mediation with the former employee. The Company has granted that request, but the former employee declined to participate in mediation.  On July 17, 2012, the U.S. DOL conducted interviews of several former CDTI officers.  On July 31, 2012, the Company submitted Supplemental Briefing to the U.S. DOL pertaining to the protections and applicability of Section 806 of the Sarbanes-Oxley Act of 2002.  The U.S. DOL’s investigation is ongoing.  Based upon current information, management, after consultation with legal counsel defending the Company’s interests, believes the ultimate disposition will have no material effect upon its business, results or financial position. As no specific quantification of damages has been provided by the Claimant, the Company cannot provide a reasonable range of possible outcomes.

BP Products North America (“BP”), a subsidiary of British Petroleum (BP p.l.c.) has made claims against JM as the parent company of and purchaser of AUS, pertaining to the Whiting Refinery SPS NOx Reduction Project.  BP alleges JM is liable for default damages and various other set-offs to the contract price and has retained a significant portion of the contract amount, as well as made claims for additional damages.  JM maintains that it fully performed its obligations under the contract, and BP has acted in bad faith and has inappropriately withheld the contract proceeds and is further liable for various other damages.  On May 12, 2010, JM tendered to the Company a claim for indemnification under the Asset Purchase Agreement dated October 1, 2009, among JM, CSI and AUS.  A recent mediation did not result in a settlement.  On May 14, 2012, JM filed a lawsuit in California state court alleging breach of contract.  On June 25, 2012, BP removed the case to federal court.  On June 29, 2012, BP filed their Answer and Counterclaimed against JM for Breach of Contract.  The Parties are now preparing for their initial disclosures.  As litigation has just begun and no discovery has been conducted, the Company cannot provide a reasonable range of possible outcomes. Any potential obligation is not expected to have a material impact on the Company, its results of operations or its financial position.

In addition to the foregoing, the Company is involved in legal proceedings from time to time in the ordinary course of its business. Management does not believe that any of these claims and proceedings against it is likely to have, individually or in the aggregate, a material adverse effect on the Company’s consolidated financial condition or results of operations.    

Sales and Use Tax Audit

The Company is undergoing a sales and use tax audit by the State of California on AUS for the period of 2007 through 2009. The audit has identified a project performed by the Company during that time period for which sales tax was not collected and remitted and for which the State of California asserts that proper documentation of resale may not have been obtained. The Company contends and believes that it received sufficient and proper documentation from its customer to support not collecting and remitting sales tax from that customer and is actively disputing the audit report with the State of California. Accordingly, no accrual has been recorded for this matter. The potential outcomes of this matter range from zero to $1.3 million. Should the Company not prevail in this matter, it has certain indemnifications from its customer related to sales tax and would pursue reimbursement from the customer for all assessments from the State.  

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12.  Segment Reporting

The Company has two division segments based on the products it delivers:

Heavy Duty Diesel Systems division — The Heavy Duty Diesel Systems division designs and manufactures verified exhaust emissions control solutions.  This division offers a full range of products for the verified retrofit and OEM markets through its distributor/dealer network and direct sales. The ECS and Clean Diesel Technologies-branded products are used to reduce exhaust emissions created by on-road, off-road and stationary diesel and alternative fuel engines including propane and natural gas. The retrofit market in the U.S. is driven in particular by state and municipal environmental regulations and incentive funding for voluntary early compliance. The Heavy Duty Diesel Systems division derives significant revenues from retrofit with a portfolio of solutions verified by the California Air Resources Board and the United States Environmental Protection Agency.

Catalyst division — The Catalyst division produces catalyst formulations to reduce emissions from gasoline, diesel and natural gas combustion engines that are offered for multiple markets and a wide range of applications.  A family of unique high-performance catalysts has been developed — with base-metals or low platinum group metal and zero platinum group metal content — to provide increased catalytic function and value for technology-driven automotive industry customers. The Catalyst division’s technical and manufacturing competence in the light duty vehicle market is aimed at meeting auto makers’ most stringent requirements, and it has supplied over ten million parts to light duty vehicle customers since 1996. The Catalyst division also provides catalyst formulations for the Company’s Heavy Duty Diesel Systems division. Intersegment revenues are based on market prices.

Corporate — Corporate includes cost for personnel, insurance and public company expenses such as legal, audit and taxes that are not allocated down to the operating divisions.

Summarized financial information for the Company’s reportable segments is as follows (in thousands):

(1)    Elimination of Catalyst revenue and profit in ending inventory related to sales to Heavy Duty Diesel Systems.

The Company conducted an intercompany transfer pricing study at the end of 2011 which resulted in it adjusting the prices its group companies charge each other for the sale of products and services. The Catalyst division adjusted certain prices it charges for products sold to the Heavy Duty Diesel Systems division to be consistent with market prices. The impact for the full year was recorded in the fourth quarter of 2011 which resulted in a $1.3 million increase in revenues for the Catalyst division and the offsetting intercompany eliminations.  The change also resulted in a $1.3 million decrease in loss from continuing operations for the Catalyst division with an offsetting decrease in income from continuing operations for the Heavy Duty Diesel Systems division for the year ended December 31, 2011. Of this amount, $1.0 million related to previous interim periods in 2011 with the impact on the individual quarters of $0.1 million, $0.4 million and $0.5 million for the quarters ended March 31, June 30, and September 30, 2011, respectively. Catalyst division revenues and eliminations and the Heavy Duty Diesel Systems and Catalyst income (loss) from operations for the three and nine months ended September 30, 2011 have been recast to reflect the impact of this change in measurement. The change in intercompany pricing did not result in any change in consolidated revenues or in the consolidated loss from operations. 

Net sales by geographic region are as follows (in thousands):

Geographic information is based on country of origin. The majority of Canadian sales are to U.S. customers.

Total revenue for the three months ended September 30, 2012 decreased by $0.6 million, or 3.8% to $14.4 million from $15.0 million for the three months ended September 30, 2011.

Our Heavy Duty Diesel Systems division includes on-road diesel retrofit business most often driven by increasingly stringent emission regulations as well as product applications sold on an OEM and aftermarket basis with applications for the reduction of exhaust emissions of off-road and stationary engines and licensing revenue. Revenues for our Heavy Duty Diesel Systems division for the three months ended September 30, 2012 decreased $2.4 million, or 21.6%, to $8.7 million from $11.1 million for the three months ended September 30, 2011. The decrease was due to decreased retrofit sales of $1.6 million and decreased non-retrofit sales of $0.8 million. Retrofit sales declined $1.1 million in the London LEZ and $0.5 million in North America. Significant programs in North America included California and New Jersey. California sales of $1.7 million continued to be weak compared to expectations and were down $2.2 million year over year as we benefited from a CARB early compliance incentive program which was implemented in the second and third quarters of 2011. This decline was partially offset by growth driven by sales in the New Jersey Department of Environmental Protection Mandatory Diesel Retrofit Program and in other retrofit programs in North America. Non-retrofit sales decreased due to declines in sales of standard exhaust parts in North America, European material handling sales and North American sales to OEMs and integrators.

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Total revenues for our Catalyst division for the three months ended September 30, 2012 increased $0.3 million, or 3.3%, to $6.7 million from $6.4 million for the three months ended September 30, 2011. Excluding intercompany revenue, sales for this division increased 46.7% to $5.7 million for the three months ended September 30, 2012 as compared to $3.9 million for the three months ended September 30, 2011. The increase was in part due to the recognition of $1.0 million in revenue upon completion of performance under a contract to provide equipment, engineering and support services to assist our investment partner in the Asia Pacific, TKK, in establishing operations in China to manufacture automotive and exhaust emission products for the China market. The remaining increase was due to an increase of $1.0 million in sales to our Japanese OEM customer due to higher vehicle shipments, expansion of our catalysts onto new vehicle platforms, increased purchasing by the customer to build an initial stock of parts for a new model and rare earth material price increases that were passed on to the customer. This was partially offset by reductions of $0.2 million in sales to other OEM customers for the three months ended September 30, 2012 as compared to the three months ended September 30, 2011. We eliminate intercompany sales by the Catalyst division to our Heavy Duty Diesel Systems division in consolidation.  

Cost of revenues

Cost of revenues decreased by $0.2 million, or 1.7% to $10.5 million for the three months ended September 30, 2012, compared to $10.7 million for the three months ended September 30, 2011. The primary reason for the decrease in costs was lower product sales volume.  

Gross profit

The following table shows our gross profit and gross margin (gross profit as a percentage of revenues) by division for the periods indicated.

(1)   Division calculation based on division revenue. Total based on total revenue.

Gross profit for the three months ended September 30, 2012 decreased by $0.4 million, or 9.3%, to $3.9 million from $4.3 million for the three months ended September 30, 2011. Gross margin was 26.9% during the three months ended September 30, 2012 compared to 28.5% during the three months ended September 30, 2011.

The decrease in gross margin for our Heavy Duty Diesel Systems division from 28.5% for the three months ended September 30, 2011 to 25.7% for the three months ended September 30, 2012 is a result of reduced leverage of fixed manufacturing costs resulting from lower sales volume, $0.3 million of warranty expense and increased inventory obsolescence of $0.2 million.   

The increase in gross margin for our Catalyst division from 18.4% for the three months ended September 30, 2011 to 23.7% for the three months ended September 30, 2012 is due to the impact of favorable margins under the TKK contract which was completed during the three months ended September 30, 2012. The TKK contract was a non-standard contract for the Company and is not expected to occur on a regular basis. Excluding this impact, gross margins for our Catalyst division decreased to 14.9% for the three months ended September 30, 2012 from 18.4% for the three months ended September 30, 2011. This decrease in gross margin is a result of the escalation of prices of rare earth materials that we use in our catalysts. One of our OEM customers provides price adjustments to isolate us from the impact of rare earth cost increases. Through June 2012, that customer was reimbursing us the full amount actually spent by us on these materials. In the third quarter and beyond, it is the intent of both us and our customer to establish a formula for this reimbursement which is based on formulae established by this customer with other vendors. Until such a formula is agreed to, our customer is only partially reimbursing rare earth cost increases. We expect that a formula will be agreed to before the end of the year. With the significant increases in rare earth prices, this cost reimbursement is dilutive to margin on a percent of sales. With two of our other OEM customers, we were not reimbursed for the increased costs of the rare earth material but are pursuing both for retroactive reimbursement for the as well as for future business.

For the three months ended September 30, 2012, operating expenses decreased by $0.5 million to $5.0 million from $5.5 million for the three months ended September 30, 2011.

Selling, general and administrative expenses

For the three months ended September 30, 2012, selling, general and administrative expenses decreased by $0.5 million, or 13.2%, to $3.4 million from $3.9 million for the three months ended September 30, 2011. This decrease is a result of a reduction in costs related to the former Corporate office in Connecticut of $0.2 million, our London operation of $0.1 million and a reduction in stock compensation and bonus $0.2 million. Selling, general and administrative expenses as a percentage of revenues decreased to 23.4% in the three months ended September 30, 2012 compared to 26.0% in the three months ended September 30, 2011.  

Research and development expenses

Research and development expenses were $1.6 million in each of the three months ended September 30, 2012 and 2011. As a percentage of revenues, research and development expenses were 11.4% in the three months ended September 30, 2012, compared to 10.8% in the three months ended September 30, 2011.

Other expense

The following table shows the components of other expense and other (expense) income as a percentage of revenues for the periods indicated.

We incurred interest expense of $0.4 million in the three months ended September 30, 2012 compared to $0.3 million in the three months ended September 30, 2011. The three months ended September 30, 2012 includes $0.1 million in financing costs related to the amendment of our FGI credit facility (see —Description of Indebtedness below and Note 7 to our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q. For the three months ended September 30, 2012, there was a loss of $0.1 million related to the change in fair value of liability classified common stock warrants. The three months ended September 30, 2012 included a $0.4 million exchange loss related primarily to changes in value of the Canadian dollar in relation to the U.S. dollar as compared to a gain of $0.2 million in the three months ended September 30, 2011.

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Net loss

For the foregoing reasons, we had a net loss of $1.8 million for the three months ended September 30, 2012 compared to a net loss of $2.0 million for the three months ended September 30, 2011. Excluding net income of $0.2 million in the three months ended September 30, 2012 from discontinued operations and net loss of $0.1 million in the three months ended September 30, 2011, we had a net loss from continuing operations of $2.0 million for the three months ended September 30, 2012 compared to a net loss from continuing operations of $1.9 million for the three months ended September 30, 2011.We continue to have legal and other expenses as well as gains on litigation settlements related to the 2009 divestiture of the assets of Applied Utility Systems. We record these activities as discontinued operations. For additional information relating to Applied Utility Systems, see Note 17 to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2011.

Comparison of Nine Months Ended September 30, 2012 to Nine Months Ended September 30, 2011

Revenues  

Total revenue for the nine months ended September 30, 2012 increased by $7.8 million, or 19.4%, to $48.1 million from $40.3 million for the nine months ended September 30, 2011.

Revenues for our Heavy Duty Diesel Systems division for the nine months ended September 30, 2012 increased $2.2 million, or 7.2%, to $32.3 million from $30.1 million for the nine months ended September 30, 2011. The increase was due to increased retrofit sales of $2.5 million partially offset by decreased non-retrofit sales of $0.3 million. Retrofit sales increased $4.0 million in the London LEZ and decreased $1.5 million in North America. Significant programs in North America included California, New Jersey and Texas. California sales of $6.2 million continued to be weak compared to expectations and were down $1.5 million year over year as we benefited from a CARB early compliance incentive program which was implemented in the second and third quarters of 2011. Sales increased $3.0 million under the New Jersey Department of Environmental Protection Mandatory Diesel Retrofit Program, increased $1.0 million for the retrofit of school buses in the State of Texas and decreased $4.0 million related to the retrofit of school buses in New York and other northeastern states. Non-retrofit sales decreased due to declines in European material handling sales and North American sales to OEMs and integrators.

Revenues for our Catalyst division for the nine months ended September 30, 2012 increased $4.2 million, or 27.9%, to $19.2 million from $15.0 million for the nine months ended September 30, 2011. Excluding intercompany revenue, sales for this division increased $5.6 million, or 55.5%, to $15.8 million for the nine months ended September 30, 2012 as compared to $10.2 million for the nine months ended September 30, 2011. The nine months ended September 30, 2012 includes the recognition of $1.0 million in revenue upon completion of performance under the contract with TKK, as discussed above. The remaining increase was due to an increase in sales to our Japanese OEM customer of $6.0 million, of which $1.2 million was as a result of increased prices of rare earth raw materials that were passed on to the customer. This was offset by a reduction of $1.4 million in sales to other OEM customers for the nine months ended September 30, 2012 as compared to the nine months ended September 30, 2011. We eliminate intercompany sales by the Catalyst division to our Heavy Duty Diesel Systems division in consolidation.

Cost of revenues