<select name="Categoría" id="Categoría1">
<option value="0" selected>Seleccionar</option>
<?php
$directorio = mysql_query("SELECT direct_id, direct_prod FROM directorio");
while ($registroprod = mysql_fetch_array($directorio)) {
?>
<option value="<?php echo $registroprod['direct_id']; ?>">
<?php echo utf8_decode($registroprod['direct_prod']); ?></option>
<?php
}
mysql_free_result($directorio);
?>
</select>
usa utf8_decode o utf8_encode;
http://pa.php.net/utf8_decode
salu2