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CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

        As used in this Quarterly Report on Form 10-Q, the terms “CDTi” or the “Company” or “we,” “our” and “us” 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 including, but not limited to, the risks and uncertainties discussed in Part I - Item 1A “Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2012, filed with the Securities and Exchange Commission (the “SEC”) on March 27, 2013, and other risks and uncertainties discussed in our other filings with the SEC, such as the following:

PART I—FINANCIAL INFORMATION

Item 1. Financial Statements

Condensed Consolidated Balance Sheets

(In thousands, except share and per share amounts)

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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CLEAN DIESEL TECHNOLOGIES, INC.

Condensed Consolidated Statements of Operations and Comprehensive Loss

(In thousands, except per share amounts)

(Unaudited)

See accompanying notes to the condensed consolidated financial statements.

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CLEAN DIESEL TECHNOLOGIES, INC.

Condensed Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)

See accompanying notes to the condensed consolidated financial statements.

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CLEAN DIESEL TECHNOLOGIES, INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

1.       Organization 

a.       Description of Business

        Clean Diesel Technologies, Inc. (“CDTi” or the “Company”) is a technology-focused, global manufacturer and distributor of light duty vehicle and heavy duty diesel emissions control systems and products to major automakers, integrators and retrofitters. It has over 30 years of experience in the heavy duty diesel systems market and proven technical and manufacturing competence in the light duty vehicle catalyst market meeting auto makers’ stringent requirements. CDTi’s 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, France, Japan and Sweden as well as an Asian investment and European joint venture.

b.       Liquidity 

        The Company has suffered recurring losses and negative cash flows from operations since inception, resulting in an accumulated deficit of $178.1 million at June 30, 2013. The Company has 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 June 30, 2013, the Company had $4.7 million in borrowings outstanding under this facility with $2.8 million available, subject to the availability of eligible accounts receivable and inventory balances for collateral. There is no guarantee that the Company will be able to borrow to the full limit of $7.5 million if FGI chooses not to finance a portion of its receivables or inventory. Additionally, FGI can cancel the facility at any time.

        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 limited to $0.5 million to $1.5 million per sale, depending on the price of the Company’s common stock as set forth in the purchase agreement. The Company currently has registered 1,702,836 shares for purchase shares under the agreement. However, the aggregate number of shares issued pursuant to the purchase agreement is limited to 1,434,994 shares of common stock (19.99% of the outstanding shares of the Company’s common stock on October 7, 2011, the date of the purchase agreement) (the “Exchange Cap”), unless and until shareholder approval is obtained. The Exchange Cap is not applicable for at-market transactions, defined as when the average price for all shares purchased pursuant to the purchase agreement is greater than or equal the signing price per the agreement of $2.76 plus $0.254, or $3.014 per share. Assuming a purchase price of $1.21 per share (the closing sale price of the Company’s common stock on June 30, 2013) and the purchase by LPC of the full 1,702,836 currently registered purchase shares, proceeds to the Company would be $2.1 million. If the purchase was limited to the Exchange Cap of 1,434,994 shares, the proceeds to the Company would be $1.7 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 Securities and Exchange Commission (“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, provided that we may not sell our securities in a primary offering pursuant to the Shelf Registration or any other registration statement on Form S-3 with a value exceeding one-third of our public float in any 12-month period (unless our public float rises to $75.0 million or more). On July 3, 2013, the Company sold 1,730,000 units for $1.25 per unit consisting of one share of common stock and one half of a warrant to purchase one share of common stock with an exercise price of $1.25 per share. The Company received net proceeds of $1.7 million after deducting discounts and commissions to the underwriter and estimated offering expenses. See Notes 9 and 15.

        On June 28, 2013, the Company and one of its directors entered into an agreement pursuant to which the director agreed to purchase $100,000 of the Company’s common stock in a private placement for $1.84 per share, the closing bid price on the day preceding the date of the agreement. In July 2013, the Company issued 54,347 shares of common stock to the director pursuant to this agreement.

        On January 30, 2013, the Company and Kanis S.A. agreed to amend certain terms of the Company’s outstanding 6% shareholder note due 2013 to change the maturity date from June 30, 2013 to June 30, 2015 and to increase the interest rate from 6% to 8% beginning on June 30, 2013. In addition, the payment premium due under this note was changed from a range of $100,000 to $200,000, based proportionally on the number of days that the loan remains outstanding, to a fixed amount of $250,000 with $100,000 payable on June 30, 2013 and the remaining amount payable at maturity on June 30, 2015. Concurrent with its July 3, 2013 public offering, the Company converted $235,000 of premium and interest due June 30, 2013, pursuant to loans made to the Company by Kanis S.A., to 188,000 shares of common stock and warrants to purchase 94,000 shares of common stock.

        Also on January 30, 2013, the Company and Kanis S.A. entered into a letter agreement regarding the Company’s 8% subordinated convertible notes due 2016 whereby Kanis S.A. agreed not to accelerate the maturity of these convertible notes during the 2013 calendar year.

        At June 30, 2013, the Company had $3.2 million in cash. As discussed above, on July 3, 2013, the Company completed a public offering of common stock resulting in net proceeds of approximately $1.7 million after deducting discounts and commissions to the underwriter and related offering expenses.  In addition, pursuant to letter agreements entered into with Kanis S.A. and one of the Company’s directors on June 28, 2013, on July 3, 2013, the Company issued shares and warrants to Kanis S.A. and the director for an aggregate purchase price of $235,000 and $100,000, respectively.  The investment by Kanis S.A. reflects conversion into shares of common stock and warrants of premium and interest due on June 30, 2013, pursuant to loans made to the Company.  See Notes 8 and 15.

        Management believes that the Company has sufficient working capital to fund operations through the end of this year and into next year. However, there can be no assurances that the Company will be able to achieve projected levels of revenue in 2013 and beyond. If cash from operations is not sufficient for the working capital needs of the Company, the Company may seek additional financing in the form of funding from outside sources. In this regard, the Company may attempt to, among other things, (i) utilize potential availability under its line of credit with FGI; (ii) sell shares of common stock under its purchase agreement with LPC; or (iii) pursue an offering of equity or debt securities. However, there is no assurance that the Company will be able to raise additional funds or reduce its discretionary spending at a level sufficient for its working capital needs.               

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 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 (“U.S. GAAP”), 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, 2012.

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 U.S. GAAP requires management of the Company to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. These estimates and assumptions are based on management’s best estimates and judgment. On an ongoing basis, the Company evaluates its estimates and assumptions, including those related to impairment of goodwill and long-lived assets, stock-based compensation, the fair value of financial instruments including warrants, allowance for doubtful accounts, inventory valuation, taxes and contingent and accrued liabilities. The Company bases its estimates on historical experience and various other factors, including the current economic environment, which it believes to be reasonable under the circumstances. Estimates and assumptions are adjusted when facts and circumstances dictate. Actual results may differ from these estimates under different assumptions and conditions. Management believes that the estimates are reasonable.

d.       Concentration of Risk

        For the three and six months ended June 30, 2013, one automotive original equipment manufacturer (“OEM”) customer within the Catalyst segment accounted for 41% of the Company’s revenues. This customer accounted for 33% and 28%, respectively, of the Company’s revenues for the three and six months ended June 30, 2012. No other customers accounted for 10% or more of the Company’s revenues during these periods.

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CLEAN DIESEL TECHNOLOGIES, INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

        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 and customer B is a diesel system distributor.

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

        Vendors A and C above are substrate suppliers, vendor B above is a catalyst supplier and vendor D is a rare earth materials supplier.

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 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 months ended June 30, 2013 and 2012, 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 of Financial Instruments

        Accounting Standards Codification (“ASC”) Topic 825, “Financial Instruments,” requires disclosure of the fair value of financial instruments for which the determination of fair value is practicable. The fair values of the Company’s cash, 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 the variable interest rates. The fair value of shareholder notes payable, calculated using level 3 inputs, including a Black-Scholes option-pricing model to value the debt’s conversion factor and a net present value model is $7.4 million at June 30, 2013.

        Certain prior-period amounts have been reclassified to conform to the current period presentation. These changes had no impact on the previously reported consolidated results of operations or stockholders' equity.

h.       Recently Adopted Accounting Guidance

In February 2013, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update ASU No. 2013-02, "Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income," which requires disclosure of significant amounts reclassified out of accumulated other comprehensive income by component and their corresponding effect on the respective line items of net income. This guidance is effective for reporting periods beginning after December 15, 2012.  Adoption of this guidance on January 1, 2013 did not have a material impact on the Company’s consolidated financial statements or financial statement disclosures.

i.         Recently Issued Accounting Guidance           

In March 2013, the FASB issued ASU No. 2013-05, "Parent's Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity or of an Investment in a Foreign Entity," ("ASU 2013-05"). The objective of ASU 2013-05 is to resolve the diversity in practice regarding the release into net income of the cumulative translation adjustment upon derecognition of a subsidiary or group of assets within a foreign entity. ASU 2013-05 is effective for reporting periods beginning after December 15, 2013 and is not expected to have a material impact on the Company’s consolidated financial statements or financial statement disclosures.

In June 2013, the FASB ratified Emerging Issues Task Force (EITF) Issue 13-C, “Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists” which concludes an unrecognized tax benefit should be presented as a reduction of a deferred tax asset when settlement in this manner is available under the tax law. The Company will adopt this amendment in the first quarter of 2014 and does not expect adoption of this standard to have a material impact on its consolidated financial statements or financial statement disclosures.

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 six months ended June 30, 2013 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 June 30, 2013 and 2012.  The Company recorded amortization expense related to amortizable intangible assets of $0.4 million during each of the six months ended June 30, 2013 and 2012.

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

5.       Accrued Expenses and Other Current Liabilities

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

6.       Severance and Other Charges

        During 2012, the Company initiated actions to streamline both its facilities and its workforce. These actions were deemed necessary to meet the demands of the markets served by the Company and the economic environment and to improve profitability. In 2012, the Company terminated 41 employees throughout North America, Europe, the United Kingdom and Asia. The Company also incurred lease termination costs related to the exit of a lease in North America and asset impairment expense related to the exit of this facility as well as to the exit of a leased facility in the United Kingdom. In 2013, the Company terminated 2 employees in the United Kingdom related to these actions.

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CLEAN DIESEL TECHNOLOGIES, INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

        The following summarizes the activity in the Company’s accrual for severance and other charges (in thousands):

        The Company expects to pay substantially all of the remaining amounts during the year ended December 31, 2013.

7.       Accrued Warranty

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

8.       Debt 

        Debt consists of the following (in thousands):

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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. However, FGI can cancel the facility at any time.

        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. At June 30, 2013, the inventory sublimit amount was 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, as amended, is the greater of (i) 6.50% per annum and (ii) 2.50% per annum above the prime rate, as defined in the FGI Facility. Any advances or borrowings under the FGI Facility are due on demand. The Company also agreed to pay FGI collateral management fees of 0.30% per month on the face amount of eligible receivables as to which advances have been made and 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.     

        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. 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 June 30, 2013, the Company had $4.0 million of gross accounts receivable pledged to FGI as collateral for short-term debt in the amount of $2.9 million. At June 30, 2013, the Company also had $1.8 million in borrowings outstanding against eligible inventory. The Company was in compliance with the terms of the FGI Facility at June 30, 2013. However, there is no guarantee that the Company will be able to borrow to the full limit of $7.5 million if FGI chooses not to finance a portion of its receivables or inventory.

        8% Shareholder Note Due 2015

        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 is unsecured and bears interest on the unpaid principal at a rate of 6%, with interest only payable quarterly in arrears, commencing March 31, 2011. In addition to principal and accrued interest, the Company was obligated to pay Kanis S.A. at maturity a “Payment Premium” ranging from $100,000 to $200,000 based proportionally on the number of days that the loan remains outstanding. There is no prepayment penalty. The loan originally matured on June 30, 2013. On January 30, 2013, the Company and Kanis S.A. agreed to amend certain terms of the loan to change the maturity date from June 30, 2013 to June 30, 2015 and to increase the interest rate from 6% to 8% beginning on June 30, 2013. In addition, the payment premium due under this note was changed to a fixed amount of $250,000 with $100,000 payable on June 30, 2013 and the remaining amount payable at maturity on June 30, 2015.

        On June 28, 2013, the Company and Kanis S.A. entered into a letter agreement pursuant to which Kanis S.A. agreed that the $100,000 payment premium due June 30, 2013 and $135,000 in accrued interest on the shareholder notes payable to Kanis S.A. as of June 30, 2013 could be paid, at the option of the Company, in cash or by issuance of equity securities of the Company. On July 3, 2013, concurrent with the closing of its public offering, the Company issued to Kanis S.A. comprised of 188,000 shares of common stock and warrants to purchase up to 94,000 shares of common stock at $1.25 per share, in satisfaction of the payment premium and accrued interest, as described above. See Note 15.     

        In connection with the original 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.

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CLEAN DIESEL TECHNOLOGIES, INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

        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. On January 30, 2013, the Company and Kanis S.A. entered into a letter agreement regarding the Notes whereby Kanis S.A. agreed not to accelerate the maturity of these convertible notes during the 2013 calendar year. 

        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.

        The outstanding principal balance of the Notes, plus accrued and unpaid interest were convertible into shares of the Company’s common stock at an initial conversion price equal to $7.044 per share, which was 120% of the closing bid price per share of the Company’s common stock on April 8, 2011, into no more than 369,853 shares. The Company evaluated the Notes and determined that there were no embedded derivatives contained in the Notes that require separate accounting. Additionally, there was no beneficial conversion feature associated with the Notes since the conversion price was not lower than the estimated fair market value of the Company’s common stock on the issuance date. As such, the entire proceeds from the Notes are recorded as debt in the condensed consolidated balance sheets.

        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 the Notes, and accrued and unpaid interest 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. The Company evaluated the modification and determined that the modification was not substantial and did not qualify as a debt extinguishment. Accordingly, no gain or loss was recognized from the modification.

        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 the 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 becomes 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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CLEAN DIESEL TECHNOLOGIES, INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

9.       Stockholders’ Equity

        At June 30, 2013, the Company had 24.1 million shares authorized, 24.0 million of which are $0.01 par value common stock and 0.1 million of which are $0.01 par value preferred stock.

        On June 28, 2013, the Company and one of its directors entered into an agreement pursuant to which the director agreed to purchase $100,000 of the Company’s common stock in a private placement at a price of $1.84 per share, the closing bid price on the day preceding the date of the agreement. In July 2013, the Company issued 54,347 shares of common stock to the director under this agreement.

        Shelf Registration

        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. However, we may not sell our securities in a primary offering pursuant to the Shelf Registration or any other registration statement on Form S-3 with a value exceeding one-third of our public float in any 12-month period (unless our public float rises to $75.0 million or more). 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 June 28, 2013, the Company entered into an underwriting agreement (the “Underwriting Agreement”) with Roth Capital Partners, LLC, (the “Underwriter”) related to the public offering (the “Offering”) of an aggregate 1,600,000 shares of the Company’s common stock together with warrants to purchase up to 800,000 shares  of common stock. The warrants are exercisable any time until five years from the date of issuance at a price of $1.25 per share. The securities were sold in units consisting of one share of common stock and one half of a warrant to purchase one share of common stock for a price of $1.25 per unit. The Underwriters were also granted a 30 day option to purchase up to an additional 240,000 shares of common stock and/or warrants to purchase up to an additional 120,000 shares of common stock to cover overallotments, if any. The offering was made pursuant to the Company’s Shelf Registration discussed above. The offering closed on July 3, 2013. The Company received net proceeds of approximately $1.7 million after deducting discounts and commissions to the Underwriter and estimated offering expenses. See Note 15, “Subsequent Events” for further discussion. The financial statements as of June 30, 2013 do not include any adjustments related to this offering.

        Common Stock Purchase Agreement with LPC

        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 the Company’s 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 limited to $0.5 million to $1.5 million per sale, depending on the price of the Company’s common stock as set forth in the Purchase Agreement, up to the aggregate amount of $10.0 million. The aggregate number of shares issued pursuant to the Purchase Agreement is limited to 1,434,994 shares of common stock (19.99% of the outstanding shares of the Company’s common stock on October 7, 2011, the date of the Purchase Agreement) (the “Exchange Cap”), unless and until shareholder approval is obtained. The Exchange Cap is not applicable for at-market transactions, defined as when the average price for all shares purchased pursuant to the purchase agreement is greater than or equal the signing price of $2.76 plus $0.254, or $3.014 per share.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 the Company’s common stock on the purchase date or the average of the three lowest closing sales prices of the Company’s 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 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.

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CLEAN DIESEL TECHNOLOGIES, INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

       10.    Warrants 

        From time to time, the Company issues warrants to purchase its common stock. These warrants have been issued for consulting services, in connection with the Company’s issuance of debt and sales of its common stock.

        Warrant activity 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 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 June 30, 2013 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 liability, included in accrued expenses and other current liabilities in the accompanying condensed consolidated balance sheets, is remeasured at the end of each reporting period with changes in fair value recognized in other income (expense) in the condensed 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):

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CLEAN DIESEL TECHNOLOGIES, INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

11.    Stock-Based Compensation

        The Clean Diesel Technologies, Inc. Stock Incentive Plan, as amended (the “Plan”), provides 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 combinations of these to the Company’s directors, officers, employees, consultants and advisors (except consultants or advisors in capital-raising transactions) as determined by the board of directors. As of June 30, 2013, there were 374,207 shares available for future grants under the Plan.

        Total stock-based compensation expense for both employee and non-employee awards for the three and six months ended June 30, 2013 was $0.2 million and $0.4 million, respectively. Total stock-based compensation expense for both employee and non-employee awards for the three and six months ended June 30, 2012 was $0.1 million and $0.2 million, respectively.

Stock Options

        Stock option activity 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 six months ended June 30, 2012 is summarized below. There were no issuances of stock options during the six months ended June 30, 2013.

        Compensation costs for stock options that vest over time are recognized over the vesting period on a straight-line basis. As of June 30, 2013, the Company had $0.5 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 1.9 years.

        There was no cash received from option exercises under any share-based payment arrangements for the six months ended June 30, 2013 or 2012.

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CLEAN DIESEL TECHNOLOGIES, INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

        Restricted Share Units              

RSU activity is as follows:

        During the six months ended June 30, 2013, the Company granted 254,411 RSUs to executive officers and other key employees. The RSUs are time-based with 225,221 vesting over three years with the remaining 29,190 vesting approximately one year from the date of grant.

        As of June 30, 2013, the Company had approximately $0.7 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.

12.    Joint Venture

On February 19, 2013, the Company entered into a joint venture agreement (the “Joint Venture Agreement”) with Pirelli & C. Ambiente SpA (“Pirelli”) to form a joint venture entity, Eco Emission Enterprise Srl under the laws of Italy (the “Joint Venture”), through which the Company and Pirelli will jointly sell their emission control products in Europe and the Commonwealth of Independent States (“CIS”) countries beginning in the second quarter of 2013. Pursuant to the agreement, both partners will sell products to the Joint Venture which will earn a commission to market and sell these products. As such, all of the Company’s existing business in Sweden and the UK will be conducted through the Joint Venture. The Joint Venture commenced operations in April 2013.

The Joint Venture Agreement provides that the Company and Pirelli will each hold 50% of the total issued share capital of the Joint Venture. Pursuant to the Joint Venture Agreement, in February 2013, the Company and Pirelli each contributed €50,000 (approximately $66,000) to the Joint Venture as initial capital contributions. In addition, in accordance with the Joint Venture Agreement, CDTi and Pirelli provided shareholder loans of €200,000 (approximately $261,000) each in April 2013. On July 25, 2013, the Company and Pirelli agreed to convert €175,000 each of their shareholder loans to the Joint Venture into equity contributions as required by local statutory regulations.

Future contributions from the Company and Pirelli will be provided to the Joint Venture in the form of cash or shareholders loans, from time to time as necessary.

13.    Contingencies 

        Legal Proceedings

        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.

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Notes to Condensed Consolidated Financial Statements

(Unaudited)

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 financial position, results of operations, or cash flows.

        BP Products North America (“BP”), a subsidiary of British Petroleum (BP p.l.c.) had made claims against Johnson Matthey (“JM”) as the parent company of and purchaser of Applied Utility Systems, Inc. (“AUS”), a former subsidiary of the Company, pertaining to the Whiting Refinery SPS NOx Reduction Project. On May 12, 2010, JM tendered to the Company a claim for indemnification under the Asset Purchase Agreement dated October 1, 2009 (the “Asset Purchase Agreement”), among JM, the Company and AUS. A mediation between the parties did not result in a settlement of the claims by BP. On May 14, 2012, JM filed a lawsuit in California state court against BP alleging breach of contract. On June 25, 2012, BP removed the case to federal court. On June 11, 2013, BP, JM and the Company entered into a Settlement Agreement and Mutual Releases pursuant to which they settled all claims. An Order Dismissing All Claims and Counterclaims with Prejudice was entered by the Court on July 3, 2013. The settlement agreement had no material impact on the Company. Under the indemnification clauses of the Asset Purchase Agreement, the Company may be liable for legal expense incurred by JM.  These legal costs may be offset against funds withheld by JM from the acquisition of AUS.  At this point, the Company has not been asked to reimburse JM for any legal expense, nor does the Company know what funds are remaining from the holdback on the AUS acquisition. 

        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, results of operations or cash flows.    

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 and that the Company owes sales tax of $1.3 million. 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 as the Company does not assess a loss as being probable. 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.  

14.    Segment Reporting

        The Company has two business 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 non-retrofit OEM and aftermarket markets through its distributor/dealer network and direct sales. These 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.

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Notes to Condensed Consolidated Financial Statements

(Unaudited)

        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 eleven 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.

        Net sales by geographic region based on the location of sales organization is as follows (in thousands):

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Notes to Condensed Consolidated Financial Statements

(Unaudited)

15.    Subsequent Events

        On July 3, 2013, the Company closed a public offering in which it sold 1,730,000 shares of common stock and warrants to purchase up to 865,000 shares, including 130,000 shares and 65,000 warrants upon partial exercise of the Underwriter’s over-allotment option. The securities were sold in units consisting of one share of common stock and one half of a warrant to purchase one share of common stock for a price of $1.25 per unit. The warrants have an exercise price of $1.25 per share, and are exercisable immediately for a period of five years.  The Company received net proceeds of approximately $1.7 million after deducting discounts and commissions to the Underwriter and estimated offering expenses. The Company intends to use the proceeds for general corporate purposes, which may include working capital, general and administrative expenses, capital expenditures and implementation of its strategic priorities.

        In addition, concurrent with the offering, on July 3, 2013, the Company converted $235,000 of premium and interest due June 30, 2013, pursuant to loans made to the Company by Kanis S.A., to 188,000 shares of common stock and warrants to purchase 94,000 shares of common stock. The warrants have an exercise price of $1.25 per share, and are exercisable immediately for a period of five years. The Company relied on the private placement exemption provided by Regulation S.

        In July 2013, the Company also sold 54,347 shares of its common stock to one of its directors in a private placement pursuant to an agreement dated June 28, 2013. The shares were sold at $1.84 per share, the closing bid price on the day preceding the date of the agreement. The Company relied on the private placement exemption provided by Regulation S.

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