Good Faith and Fair Dealing

TL;DR: The implied covenant of good faith and fair dealing is embedded in every contract under U.S. law, whether the parties want it or not. It prevents one party from doing anything that would destroy or injure the right of the other party to receive the benefits of the agreement. But the doctrine varies dramatically across jurisdictions - from a gap-filler in New York to an independent tort in Montana, from a general duty in German and French civil law to something English courts have repeatedly refused to recognize. Understanding where your contract will be interpreted determines whether good faith is a background rule, a sword, a shield, or entirely absent.

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What Is Good Faith and Fair Dealing?

Good faith and fair dealing is a legal doctrine that imposes an obligation on contracting parties to act honestly and fairly in the performance and enforcement of their agreement. In the United States, this obligation is implied in every contract as a matter of law - the parties cannot disclaim it, though they can define its contours through express terms. The covenant operates as a gap-filler: it addresses situations that the express terms of the contract do not cover, preventing one party from exploiting gaps or ambiguities in ways that undermine the other party's reasonable expectations.

The Restatement (Second) of Contracts, Section 205, states that "every contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement." The Uniform Commercial Code goes further in Section 1-304, providing that "every contract or duty within the UCC imposes an obligation of good faith in its performance and enforcement." Under UCC Section 1-201(b)(20), good faith means "honesty in fact and the observance of reasonable commercial standards of fair dealing" - a definition that combines a subjective element (honesty) with an objective element (commercial reasonableness).

The practical application of the doctrine typically arises in three scenarios. First, when a contract grants one party discretion - such as a satisfaction clause, a termination right, or the right to set a price - good faith limits the exercise of that discretion. The party cannot exercise its contractual right in a way that is arbitrary, irrational, or designed to deprive the other side of the deal it bargained for. Second, when the contract is silent on a particular issue and one party's conduct, while not technically a breach of any express term, effectively destroys the value of the agreement for the other side. Third, in enforcement, where one party uses a technical default as pretext for termination when the real motivation is unrelated to the breach.

The tension between the implied covenant and express contract terms is the central challenge in this area. Courts across jurisdictions agree on one principle: the implied covenant cannot override or contradict express contractual provisions. A party cannot use good faith to rewrite a contract it freely entered. But the line between "filling gaps" and "rewriting terms" is often disputed, and different courts draw it in different places.

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Why It Matters

• Constrains discretionary rights: Many contracts grant one or both parties significant discretion - approval rights, pricing authority, renewal options, termination triggers. The good faith covenant ensures that these discretionary rights are exercised honestly and within the reasonable expectations of both parties, not weaponized to extract concessions unrelated to the contract.
• Gap-filling function: No contract, however detailed, can anticipate every contingency. Good faith fills the inevitable gaps by requiring both parties to act consistently with the purpose and spirit of the agreement, even in situations the express terms do not address.
• Damages multiplier in certain jurisdictions: In the handful of states that recognize a tort claim for breach of the implied covenant (most notably Montana, and in limited contexts California and Massachusetts for insurance contracts), a plaintiff can recover tort damages - including punitive damages - rather than being limited to contract damages. This dramatically increases exposure.
• Cross-border risk: The doctrine varies so significantly across jurisdictions that a contract governed by New York law and one governed by English law will be subject to fundamentally different good faith obligations. Parties in international transactions must understand which legal framework applies and draft accordingly.
• Performance standard baseline: Even in jurisdictions with a narrow view of the doctrine, good faith sets a floor below which conduct cannot fall. It prevents pretextual termination, bad-faith demands for modification, and strategic exploitation of the other party's contractual vulnerabilities.

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Key Elements of a Well-Drafted Good Faith Provision

1. Explicit good faith standards for discretionary decisions: Where the contract grants one party discretion (e.g., "Seller shall set the price in its reasonable discretion"), specify whether the standard is subjective good faith (honest belief), objective reasonableness (measured against market standards), or a hybrid of both. Ambiguity in the standard invites litigation.
2. Definition of "good faith" tailored to the transaction: Rather than relying solely on the implied covenant, define what good faith means in the specific commercial context. For example, in a requirements contract, good faith might be defined as ordering quantities that reflect actual business needs, not stockpiling or diverting to alternatives.
3. Interplay with express termination rights: When drafting termination provisions, address whether termination for convenience is subject to any good faith limitation (such as minimum notice periods or no-termination windows following major investments by the other party) or whether the right is truly unfettered.
4. Standards for approval and consent rights: Where a contract requires one party's approval or consent, specify the standard explicitly: "not to be unreasonably withheld, conditioned, or delayed" is the market-standard formulation. Alternatively, "in its sole and absolute discretion" signals that no good faith limitation applies to the approval decision (though courts may still scrutinize pretextual exercises).
5. Obligations during negotiation periods: If the contract contemplates future negotiation (e.g., renewal pricing, scope adjustments), specify whether the parties are obligated to negotiate in good faith and what that obligation entails - meeting deadlines, providing information, making bona fide proposals, or simply not engaging in bad faith stalling.
6. Remedies for breach of good faith obligations: Specify whether breach of a good faith obligation gives rise to a right of termination, a damages claim, injunctive relief, or a combination. Address whether a breach of the implied covenant is treated as a material breach of the contract or as a lesser violation with different remedies.
7. Exclusion of consequential damages for good faith claims: Even if the contract contains a mutual exclusion of consequential damages, consider whether that exclusion should apply to claims arising from a breach of the good faith covenant. Some courts have held that consequential damages exclusions do not apply to willful or bad-faith conduct.

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Market Position & Benchmarks

Where Does Your Clause Fall?

• Party-Relying-on-Covenant: No express good faith clause - relies entirely on the implied covenant, which provides the broadest possible scope for arguing that the other party's conduct violated the spirit of the agreement. This approach is most effective in jurisdictions like California and Montana that interpret the implied covenant expansively.
• Market Standard: Express good faith obligations attached to specific discretionary rights (approval, pricing, renewal), with a defined standard ("reasonable" or "commercially reasonable") and clear remedies. The implied covenant continues to operate in the background for matters not expressly addressed. This is the approach in most negotiated commercial agreements.
• Party-Exercising-Discretion: Express carve-outs specifying that certain rights (termination for convenience, non-renewal, pricing adjustments) may be exercised "in sole and absolute discretion" without any obligation of good faith or reasonableness. This approach attempts to limit the implied covenant's reach with respect to specifically identified decisions.

Market Data

• All 50 U.S. states recognize the implied covenant of good faith and fair dealing in contract law, though the scope and remedies vary significantly. New York applies it narrowly as a contract claim only; California applies it broadly with potential tort remedies in insurance contexts.
• Only a small number of states - Montana is the most prominent under the Montana Wrongful Discharge from Employment Act (1987) - recognize an independent tort for breach of the implied covenant in all contract types, allowing punitive damages.
• Under the UCC, the definition of good faith was expanded in the 2001 revision of Article 1 to include both "honesty in fact" and "observance of reasonable commercial standards of fair dealing." As of 2024, 49 states and the District of Columbia have adopted the revised Article 1 definition.
• In a 2023 survey of litigated good faith disputes, approximately 65% of successful claims involved the exercise of a discretionary right (termination, approval, pricing), while roughly 25% involved conduct during negotiation or renewal periods, and approximately 10% involved performance standards.
• English courts have explicitly rejected a general duty of good faith in commercial contracts in several landmark decisions, including Walford v Miles [1992] 2 AC 128 and more recently in the Braganza v BP Shipping [2015] UKSC 17 line of cases (which recognized a limited rationality constraint on discretionary powers).

Sample Language by Position

Broad Good Faith Obligation: "Each party shall act in good faith and deal fairly in the performance and enforcement of this Agreement. Without limiting the generality of the foregoing, neither party shall take any action, or fail to take any action, that would deprive the other party of the benefits reasonably expected under this Agreement. Any exercise of discretion granted under this Agreement shall be made in a commercially reasonable manner consistent with the purposes of this Agreement."

Market Standard - Targeted Good Faith: "Where this Agreement requires the consent, approval, or agreement of a party, such consent, approval, or agreement shall not be unreasonably withheld, conditioned, or delayed, unless this Agreement expressly provides that such consent, approval, or agreement may be given or withheld in such party's sole discretion. The parties shall perform their respective obligations hereunder in good faith and in accordance with reasonable commercial standards."

Limited Good Faith - Discretion Protected: "Notwithstanding any implied covenant of good faith and fair dealing or similar doctrine, each party's right to [terminate this Agreement for convenience / decline to renew / set pricing under Section X] may be exercised in such party's sole and absolute discretion, for any reason or no reason, and such exercise shall not give rise to any claim for breach of any implied covenant, provided that such party complies with the express procedural requirements set forth herein."

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Example Clause Language

In a requirements contract, the good faith obligation constrains the buyer's ordering discretion:

Requirements Contract: "Buyer shall purchase from Seller, and Seller shall sell to Buyer, all of Buyer's requirements for the Products during the Term. Buyer's requirements shall be determined in good faith based on Buyer's actual operational needs and shall not be unreasonably reduced for the purpose of purchasing substitute products from a competing supplier. A reduction in requirements resulting from Buyer's declining business operations, product discontinuation, or facility closure shall not constitute a breach of this good faith obligation."

In an employment agreement, good faith limits the employer's discretion over bonus determinations:

Discretionary Bonus: "The Company shall determine the amount of Employee's annual bonus in its good faith discretion, taking into account Employee's individual performance, the Company's financial results, and market compensation data for comparable positions. The Company shall provide Employee with a written explanation of the basis for any bonus determination that is less than 75% of the target bonus amount."

In a distribution agreement, good faith applies to the supplier's exercise of termination and territory rights:

Distribution Agreement: "Supplier shall not exercise its right to appoint additional distributors in the Territory, or to reduce the Territory, in a manner that is inconsistent with the reasonable commercial expectations of Distributor at the time of entering into this Agreement. Any reduction in the Territory shall be made in good faith and only upon 180 days' prior written notice, accompanied by a written explanation of the commercial reasons for such reduction."

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Common Contract Types

• Insurance contracts: The implied covenant plays an outsized role in insurance law, where the insurer's duty to handle claims in good faith is a cornerstone obligation. In many states, bad faith claims handling gives rise to tort liability with punitive damages, making this the most consequential application of the doctrine.
• Requirements and output contracts (UCC Article 2): UCC Section 2-306 imposes an express good faith limitation on the buyer's stated requirements and the seller's tendered output, preventing unreasonable variations from prior demand or supply patterns.
• Employment agreements: Good faith limits the employer's exercise of discretionary compensation decisions (bonuses, equity vesting acceleration, performance ratings) and, in Montana, creates an independent cause of action for wrongful discharge outside the at-will framework.
• Franchise agreements: The franchisor's exercise of approval rights, territory decisions, and renewal determinations are subject to the implied covenant, and many state franchise laws impose additional statutory good faith obligations on franchisors.
• Joint venture and partnership agreements: Partners and joint venturers owe heightened duties of good faith under both contract law and fiduciary duty principles, creating overlapping obligations that are often litigated together.
• Commercial leases: Landlord consent to assignment or subletting, co-tenancy enforcement, and CAM reconciliation are all areas where the implied covenant constrains the landlord's discretion, even where the lease grants "sole discretion" approval rights.
• Software licensing and SaaS agreements: Good faith applies to the licensor's exercise of audit rights, usage metering discretion, and determinations of "material breach" that trigger termination. In cloud agreements, the provider's modifications to service levels and deprecation of features are also constrained.
• Construction contracts: The owner's approval of design changes, progress payment certifications, and substantial completion determinations are subject to good faith requirements, with disputes frequently litigated under both the implied covenant and specific contract provisions.

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Negotiation Playbook

Key Drafting Notes

• Do not try to disclaim the implied covenant entirely: In most U.S. jurisdictions, the implied covenant cannot be waived or disclaimed. Attempts to do so are generally unenforceable. Instead, define the covenant's scope by specifying express standards for discretionary rights, which courts will treat as the parties' agreed framework for assessing good faith.
• Use "commercially reasonable" rather than "good faith" where possible: "Commercially reasonable" provides a more objective, measurable standard than "good faith," which has both subjective and objective components depending on the jurisdiction. Tying discretionary decisions to commercial reasonableness reduces litigation risk by providing courts with a clearer benchmark.
• Address the relationship between express terms and the implied covenant: Include a clause stating that the parties intend the express terms to be the complete statement of their obligations, and that the implied covenant shall not be construed to create obligations inconsistent with the express terms. While this does not eliminate the implied covenant, it gives courts guidance on the parties' intent.
• Be specific about "sole discretion" carve-outs: If certain decisions are truly intended to be unfettered, say so explicitly and specifically. "Sole and absolute discretion, without regard to any implied covenant of good faith" is stronger than simply "sole discretion." But be aware that some courts (particularly in California) will still scrutinize the exercise for bad faith even under "sole discretion" language.
• In cross-border contracts, state the governing law with good faith in mind: If the parties want a strong good faith obligation, choose a civil law jurisdiction or a U.S. state with an expansive interpretation (California, Montana). If the parties want to minimize good faith obligations, choose English law or a U.S. state with a narrower interpretation (New York, Delaware).

Common Pitfalls

• Assuming the implied covenant creates affirmative obligations: The implied covenant generally prevents bad faith conduct but does not impose affirmative duties beyond those in the contract. A party is not required to act in the other party's best interest - only to refrain from actively undermining the other party's contractual benefits. Confusing the covenant with a fiduciary duty leads to overreliance and failed claims.
• Ignoring jurisdiction-specific variations: A good faith argument that succeeds in California may fail in New York. New York courts have held that the implied covenant "does not extend so far as to undermine a party's general right to act on its own interests" (Dalton v. Educational Testing Service). Failing to account for these differences in multi-jurisdictional agreements creates unpredictable exposure.
• Conflating good faith with reasonableness: Good faith and reasonableness are related but distinct standards. An action can be taken in good faith (honestly, without intent to harm) but still be unreasonable when measured against commercial standards. Conversely, an action that is commercially reasonable may still violate good faith if motivated by improper purposes. Draft with precision about which standard applies.
• Failing to document decision-making processes: When exercising a discretionary right (termination, non-renewal, pricing adjustment), the party exercising that right should document its reasoning contemporaneously. Courts assessing good faith look for evidence of legitimate business reasons. A well-documented decision is far more defensible than one made without any written rationale.
• Overlooking the English law position in international deals: English law does not recognize a general implied duty of good faith (Walford v Miles [1992]). Parties who assume that good faith applies to an English-law-governed contract may find themselves without a remedy for conduct that would clearly violate the implied covenant under U.S. law. If good faith is desired in an English-law contract, it must be expressed as an explicit contractual term.

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Jurisdiction Notes

• U.S.: All states recognize the implied covenant, but scope and remedies diverge sharply. New York treats it as a narrow contract-law doctrine that cannot create duties inconsistent with express terms (511 West 232nd Owners Corp. v. Jennifer Realty Co.). California applies it more broadly, including to insurance bad faith claims with tort remedies and punitive damages. Montana, under its Wrongful Discharge from Employment Act (1987), recognizes a standalone tort for breach of the implied covenant in employment and other contract contexts. The UCC definition in Section 1-201(b)(20) - "honesty in fact and the observance of reasonable commercial standards of fair dealing" - applies to all transactions governed by the Code. Delaware courts, influential in corporate and commercial disputes, apply the implied covenant as a "cautious enterprise" and will not use it to imply terms the parties could have negotiated but did not (Nemec v. Shrader, 991 A.2d 1120 (Del. 2010)).
• U.K.: English law does not recognize a general implied duty of good faith in commercial contracts. The House of Lords in Walford v Miles [1992] 2 AC 128 held that an agreement to negotiate in good faith is unenforceable because it is inherently inconsistent with the adversarial nature of negotiation. However, the Supreme Court in Braganza v BP Shipping [2015] UKSC 17 recognized that contractual discretionary powers are subject to a rationality review (analogous to Wednesbury unreasonableness in public law), providing a limited check on arbitrary exercises of contractual authority. Some specific contexts, such as relational contracts, have seen limited good faith obligations implied (Yam Seng Pte Ltd v International Trade Corporation [2013] EWHC 111 (QB)).
• Civil Law: German law imposes a pervasive duty of good faith (Treu und Glauben) under Section 242 BGB, which applies to the performance, interpretation, and enforcement of all obligations and cannot be excluded by contract. French law, following the 2016 Civil Code reform (Article 1104), provides that contracts must be "negotiated, formed, and performed in good faith" - and this provision is explicitly stated to be of public order (mandatory). Both systems treat good faith as a fundamental structural principle of contract law, in contrast to the common law approach of treating it as a limited gap-filler. Other civil law systems, including those in the Netherlands, Italy, and Japan, similarly recognize broad good faith obligations derived from their respective civil codes.

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Related Clauses

• Best Efforts - Often confused with good faith; best efforts imposes a higher affirmative obligation to pursue a particular outcome, while good faith is a baseline conduct standard.
• Termination for Convenience - The exercise of a termination-for-convenience right is one of the most frequently litigated contexts for good faith claims, particularly when the termination appears pretextual.
• Exclusivity Clause - Good faith obligations constrain the exclusive party's conduct during the exclusivity period, preventing nominal compliance while actively undermining the purpose of the exclusivity arrangement.
• Material Breach - Determining whether a breach is "material" often involves a good faith analysis, particularly when the non-breaching party is exercising termination rights based on an arguable but debatable breach.
• Waiver - A party that waives a default and then later attempts to enforce it may face a good faith challenge, particularly if the other party relied on the waiver to its detriment.
• Representations and Warranties - Good faith in making representations overlaps with fraud and misrepresentation doctrines, creating parallel liability theories when a representation is made without honest belief in its truth.

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This glossary entry is provided for informational and educational purposes only. It does not constitute legal advice, and no attorney-client relationship is formed by reading this content. Consult qualified legal counsel for advice on specific contract matters.