Good faith and fair dealing (implied covenant): what it means and how to draft it

What a good faith and fair dealing clause does

The implied covenant operates as a background rule of contract law: courts read it into most agreements whether or not the parties mention it. A good faith and fair dealing clause makes that duty explicit, signaling that neither side will exercise contractual discretion in a way that arbitrarily deprives the other of the deal’s value.

The covenant has two commonly recognized dimensions. The first is good faith performance, which limits how a party carries out its side of an existing contract (for example, how a franchisor sets fees, how a lender calls a loan, or how a buyer forecasts its requirements). The second is fair dealing, which addresses honesty, reasonable cooperation, and refraining from evasion of the spirit of the deal. Importantly, the covenant works within the contract: it cannot override an express term the parties clearly agreed to, and it does not require a party to sacrifice its own legitimate economic interests.

Drafters use the clause for several reasons: to set expectations for discretionary decisions, to reinforce cooperation obligations, and in some jurisdictions to confirm (or, where permitted, to narrow) the standard against which a party’s judgment will be measured. A clause cannot fully waive the covenant in most states, but it can define the metrics, notice, and process that show a decision was made honestly and reasonably.

Drafting example

Good faith and fair dealing. Each party shall act in good faith and deal fairly with the other in performing this Agreement and in exercising any right, discretion, or remedy granted under it. Where a party is permitted to make a determination, grant or withhold consent, or exercise discretion, it shall do so honestly, on a reasonable basis, and consistent with the parties’ reasonable expectations under this Agreement, and shall not act arbitrarily or in a manner that deprives the other party of the benefits it reasonably expected to receive. This Section does not create obligations inconsistent with the express terms of this Agreement.

Annotations: the first sentence states the general duty and, critically, extends it to the exercise of discretion, which is where most disputes arise. The phrase “honestly, on a reasonable basis” pairs a subjective standard (honesty) with an objective one (reasonableness), a formulation many courts apply. The final sentence protects your negotiated allocations by confirming that the covenant supplements, rather than contradicts, the express terms. for the governing state, because some jurisdictions apply a purely subjective good faith standard while others layer in an objective reasonableness test.

What the law says

The duty is foundational. The Restatement (Second) of Contracts Section 205 states that every contract imposes a duty of good faith and fair dealing in its performance and enforcement. For transactions in goods, the Uniform Commercial Code imposes an obligation of good faith in Section 1-304 and defines good faith to mean honesty in fact and the observance of reasonable commercial standards of fair dealing.

State law varies in important ways. Delaware, for example, treats the implied covenant narrowly as a gap-filler that applies only where the contract is silent, and it will not use the covenant to rewrite unambiguous terms. Other states apply it more broadly to police discretionary conduct. Most states treat a breach of the covenant as a contract claim rather than a tort, but a well-known exception exists in the insurance context, where bad faith can expose an insurer to tort damages. Because scope, standard, and available remedies differ by jurisdiction, the governing law clause materially affects how the covenant will be read.

One consistent theme survives across states: the covenant cannot be used to contradict an express term. If the contract plainly gives a party an unqualified right to do something, the covenant generally will not take that right away. It fills gaps and constrains discretion; it does not rebalance a bargain the parties actually struck.

Common mistakes to avoid

The most frequent error is treating the covenant as a catch-all that can override clear language. Courts routinely reject good faith arguments that ask them to defeat an express right, so build your protections into the operative terms rather than relying on the implied duty.

A second mistake is leaving discretion undefined. When a contract lets one party set prices, approve assignments, calculate earn-outs, or determine whether performance is “satisfactory,” silence invites litigation. Specify the standard (sole discretion, reasonable discretion, or a defined metric), the process, and any notice, so a later challenge has a clear yardstick.

Third, drafters often confuse good faith in performance with a duty to negotiate. In many states there is no implied duty to negotiate a new contract in good faith, and courts may refuse to enforce an unadorned agreement to agree. If you want a duty during negotiations, say so expressly and define what good faith requires.

Fourth, parties sometimes try to disclaim the covenant entirely. In most states this is ineffective, and an aggressive waiver can look like evidence of bad intent. It is usually better to define reasonable standards than to attempt a blanket disclaimer.

Finally, inconsistent drafting across a contract portfolio creates risk: one agreement grants “sole discretion,” another promises “commercially reasonable” conduct, and a third is silent. Reviewing clauses against a standard playbook keeps these choices deliberate. Pactolane’s compliance playbooks and conflict detection can flag when a discretion or good faith term deviates from your approved position, and PactAI can extract and score how each contract handles discretionary rights so a human reviewer can decide what to change.

When it matters most

The covenant matters most wherever one party holds discretion that affects the other’s economic outcome. Requirements and output contracts, exclusive dealing arrangements, franchise and distribution agreements, employment and commission plans, earn-outs in M&A, lender relationships, and any deal with consent, approval, or termination-for-convenience rights are classic battlegrounds. In each, the question is not whether a party had a right, but whether it used that right honestly and reasonably.

Timing also matters. Disputes tend to surface at renewal, at termination, or when a payment formula turns out badly for one side, so the record you build during performance (notices, reasons for decisions, and consistent application of standards) is often what decides the case. Keeping that record is a contract management discipline as much as a drafting one.

That is where disciplined contract operations pay off. A central repository with an audit trail preserves the evidence that a decision was made in good faith, renewal and deadline alerts prevent the silent lapses that trigger disputes, and standardized templates keep discretion clauses consistent across every agreement. Pactolane brings these together so the implied covenant is not left to memory: the platform stores the contract and its history, PactAI surfaces the discretionary terms and scores their risk, and your team decides how to act. Handled this way, good faith and fair dealing becomes a managed standard rather than an afterthought that only surfaces in litigation.

General legal information, not legal advice.