Implied covenant of good faith and fair dealing
An always-applicable contractual duty that cannot be eliminated by Delaware LLC Operating Agreements.
Definition
The implied covenant of good faith and fair dealing applies to every contract, including LLC Operating Agreements. Under 6 Del. C. § 18-1101(c), members can modify or eliminate explicit fiduciary duties but cannot eliminate the implied covenant.
Context
Bottom-line protection for members even when fiduciary duties are heavily modified.
Example
An Operating Agreement explicitly eliminates duty of loyalty for the controlling member. A minority member challenges a self-dealing transaction; the implied covenant still applies and the transaction may be unwound for bad faith.
Common pitfalls
- Cannot be eliminated by Operating Agreement.
- Bad-faith conduct cannot be contracted around.
What the implied covenant actually does
The implied covenant of good faith and fair dealing is a background rule that Delaware reads into every contract, including the Operating Agreement that governs a Delaware LLC. It does not add new promises out of thin air. Instead, it fills the gaps that the parties left open and asks a narrow question: if these specific people had thought about the situation at the moment they signed, would they have agreed that one side could not behave this way? When the answer is clearly yes, the covenant steps in to stop conduct that defeats the reasonable expectations the contract was built on. For a non-resident founder, the practical takeaway is that an Operating Agreement is never a complete shield against bad faith, even one drafted to give a controlling member wide discretion.
It helps to separate the implied covenant from explicit fiduciary duties. As the base glossary entry explains, members can modify or eliminate explicit fiduciary duties under 6 Del. C. section 18-1101(c), but they cannot eliminate the implied covenant. So the covenant is the floor that remains after everything else has been bargained away. It is intentionally a thin floor. Delaware courts apply it cautiously because they do not want it to become a tool for rewriting deals after the fact. A founder should not treat it as a general fairness guarantee. It is a targeted gap-filler aimed at conduct that would frustrate the bargain the parties genuinely struck.
Why a single-member founder should still care
A common assumption among non-resident founders is that the implied covenant only matters when there are multiple members fighting each other. If you own 100% of a single-member Delaware LLC, who would ever invoke a duty of good faith against you? The answer is that the relationship that matters is often not member-to-member but the company in its dealings with outside parties through contracts the LLC signs. Every commercial agreement your LLC enters, from a SaaS reseller deal to a manufacturing contract to a payment processing agreement, carries this same implied covenant. It can be asserted against your company and, in the right circumstances, asserted by your company against a counterparty who exercises contractual discretion in bad faith.
There is also a forward-looking reason single-member founders should understand the concept early. Many LLCs start with one owner and later add a co-founder, an investor, or an option-holding employee. The moment a second member arrives, the Operating Agreement becomes a live governance document and the implied covenant becomes a real constraint on how the controlling member uses discretionary power. Drafting the original agreement with that future in mind is easier than retrofitting it. Understanding the covenant now means you will not accidentally rely on a clause that a court could later read as limited by good faith. This is general information and not legal advice, so a Delaware-qualified attorney should review any agreement you expect others to join.
Discretion is the trigger
The implied covenant is most often invoked where a contract gives one party discretion. Operating Agreements are full of discretionary language: the manager may make distributions when it deems appropriate, the controlling member may approve related-party transactions, the company may call additional capital as needed. Each of those grants of discretion comes with an implied limit that the discretion will not be used to deprive the other side of the fruits of the deal. Delaware courts have repeatedly said that where a contract confers discretion, the implied covenant requires that the discretion be exercised reasonably and not arbitrarily or to recapture opportunities the parties foreclosed when they signed.
For a founder, this reframes drafting. If you want broad discretion to be truly broad, the cleaner approach is to spell out the standard that governs it rather than to leave it silent and hope. A clause that says distributions are made in the manager's sole discretion still carries the covenant. A clause that defines exactly when distributions occur, and states that no distributions are owed outside those triggers, leaves much less room for a later good-faith argument because the parties addressed the question directly. The covenant fills gaps, so the surest way to limit it is to leave fewer gaps. Precise drafting and the implied covenant are two sides of the same coin.
A worked example with a minority investor
Imagine your Delaware LLC takes on a small outside investor for 15% in exchange for capital. The Operating Agreement gives you, the 85% controlling member, the right to set your own salary as the operating manager and eliminates the explicit duty of loyalty under section 18-1101(c). A year later the company is profitable. Rather than distribute profits, where the investor would share 15%, you raise your own salary to an amount that consumes nearly all the profit, leaving almost nothing to distribute. On its face the agreement permits a salary and permits you to decide distributions. The investor sues.
Here the implied covenant does the work that the eliminated duty of loyalty no longer can. The investor would argue that no reasonable person in their position would have agreed to let the controller convert the entire shared profit pool into a one-sided salary, because that defeats the basic economic bargain of buying into the upside. A court applying the covenant asks what the parties would have agreed to had they anticipated this exact maneuver. The salary clause is not void, but using it as a device to strip the minority of any return can be challenged as bad faith. As the base entry notes, a transaction can be unwound for bad faith even where explicit duties were removed. The lesson is that contractual cleverness has an outer boundary.
How it connects to formation choices
Formation is where the covenant first becomes relevant, because the Operating Agreement is drafted around the same time you file. The Certificate of Formation itself is a short public document filed with the Delaware Division of Corporations for a $110 state fee, and it says almost nothing about governance. The real governance lives in the private Operating Agreement, and that is the contract the implied covenant attaches to. A founder who treats the Operating Agreement as a throwaway template misses the chance to set clear expectations that reduce later good-faith disputes. The $110 filing creates the entity, but the internal contract determines how discretion and fairness questions will be resolved.
Choosing single-member versus multi-member structure at formation also shapes how the covenant will operate. A genuinely single-member LLC has no internal counterparty to assert the covenant in a governance dispute, so the covenant mostly surfaces through the LLC's external contracts. A multi-member LLC puts the covenant at the center of the member relationship from day one. If you expect to raise capital or bring on partners, building the Operating Agreement with explicit distribution mechanics, defined manager standards, and clear capital-call rules at formation reduces the gaps the covenant would otherwise fill. None of this is a substitute for advice from a Delaware attorney, but understanding the connection helps you ask better questions during formation.
The covenant and your banking relationships
Non-resident founders often open US business accounts with providers such as Mercury, Wise, Relay, Lili, or Payoneer after forming the LLC and obtaining an EIN. Those account agreements are contracts, and they too carry an implied covenant of good faith and fair dealing under the law that governs them. Many of these agreements give the provider broad discretion to freeze, limit, or close accounts. The covenant does not eliminate that discretion, but in principle it constrains the provider from exercising it in a way that arbitrarily destroys the reasonable expectations the customer relied on when opening the account. In practice these are fintech partners working with chartered banks, and their terms are drafted to preserve wide latitude, so the covenant is a thin protection rather than a strong one here.
The more useful framing for a founder is operational. Because account providers retain broad contractual discretion, the realistic protection is not litigation over good faith but careful compliance so that discretion is never triggered. Keep your EIN documentation, formation papers, and beneficial ownership information consistent across every application. Avoid sudden unexplained transaction patterns that look like the activity these providers are contractually permitted to scrutinize. The implied covenant is a backstop, not a banking strategy. Treating clean documentation and predictable behavior as your primary safeguard is far more reliable than expecting a good-faith argument to reverse an account action after the fact.
Tax filings are where good faith rarely helps
It is worth being clear about where the implied covenant does not reach. Your US tax obligations are not contracts, so good faith and fair dealing do not soften them. A single-member foreign-owned LLC is generally a disregarded entity that must file Form 5472 together with a pro forma Form 1120 to report reportable transactions with its foreign owner. The penalty for failing to file is $25,000, and that penalty does not bend because a founder acted in good faith or misunderstood the requirement. The same is true of the Delaware franchise tax, a $300 flat amount due each year on June 1. These are statutory duties owed to government agencies, not contractual promises between private parties.
Founders sometimes conflate fairness in private dealings with leniency from tax authorities, and that conflation can be expensive. The implied covenant lives entirely in contract law. The IRS, the Delaware Division of Corporations, and FinCEN operate under statutes and regulations that have their own rules about reasonable cause, abatement, and relief, none of which are the implied covenant. If you face a missed Form 5472 or a late franchise tax payment, the relevant question is whether a statutory or administrative relief path applies, a matter for a tax professional. Do not assume that having behaved fairly toward your partners or vendors has any bearing on a tax penalty.
Relationship to the duty of loyalty
The base entry links this term to the duty of loyalty, and the relationship between the two is worth unpacking because founders frequently confuse them. The duty of loyalty is a fiduciary duty that, by default, requires a manager or controlling member to put the company's interests ahead of personal gain, especially in self-dealing situations. Delaware allows that explicit duty to be modified or eliminated entirely in the Operating Agreement. The implied covenant cannot be eliminated. So in a contract that strips the duty of loyalty, the covenant becomes the only remaining check on self-interested conduct, and it operates on a different and narrower theory.
The key difference is the standard each applies. The duty of loyalty asks whether a transaction was fair to the company and entered for proper purposes, a relatively searching inquiry. The implied covenant asks the much narrower question of whether one party used a discretionary power in bad faith to defeat the other's reasonable expectations under the specific bargain. A transaction can survive an implied-covenant challenge yet would have failed a loyalty analysis, simply because the covenant grants less protection. Founders who eliminate the duty of loyalty to gain flexibility should understand they are trading a robust fiduciary standard for a thinner contractual one, not for a complete absence of constraint.
Relationship to the Delaware LLC Act
The other related term in the base entry is the Delaware LLC Act, and the covenant sits inside its framework. The Act, codified at title 6 chapter 18 of the Delaware Code, is built on a policy of giving maximum effect to the freedom of contract among members. Section 18-1101 captures this in two related ways. It permits members to expand, restrict, or eliminate fiduciary duties, which is the flexibility founders prize. In the same breath it preserves the implied covenant as something members cannot bargain away. The statute therefore encodes the balance directly: broad contractual freedom on one side, an unwaivable floor of good faith on the other.
This statutory design is why Delaware is a common choice for founders who want a customizable governance structure. You can tailor almost everything else, so the covenant becomes the one fixed point. For a non-resident founder, the takeaway is that the Act rewards careful drafting and punishes sloppy reliance on defaults. Because the Act lets you eliminate so much, the gaps you leave are filled not by generous default duties but by the narrow implied covenant. Reading the Act's freedom-of-contract policy together with the unwaivable covenant gives a realistic picture of how much protection actually remains in a heavily customized agreement, which is less than many first-time founders assume.
Edge cases that surprise founders
One edge case is the difference between a gap and an express term. The implied covenant only fills genuine gaps. If the Operating Agreement expressly addresses a situation and permits the conduct in clear terms, a court will usually enforce the express term rather than override it with the covenant, because the parties already allocated that risk. This means a well-drafted clause that openly anticipates a harsh outcome can defeat a later good-faith argument, while a vague clause invites one. Founders sometimes assume the covenant rescues them from a bad bargain they actually agreed to in writing. It generally does not.
Another edge case involves the timing of expectations. The covenant measures expectations as of the moment the contract was made, not by later hindsight about what would have been fair. If circumstances change and a clause produces a result that feels unfair only because the market shifted, that alone is not bad faith. The party invoking the covenant must show that, at signing, the parties would have agreed the conduct was off-limits. A third subtle point is that the covenant protects the spirit of the specific deal, not some abstract notion of commercial fairness. Two identically worded contracts between different parties can produce different covenant outcomes because the surrounding expectations differed.
Common misunderstandings
The most frequent misunderstanding is treating the implied covenant as a general fairness or good-behavior rule. It is not. Delaware courts have been explicit that the covenant is a limited, gap-filling doctrine, not a license to rewrite contracts that turned out badly for one side. A founder who hears that good faith cannot be eliminated should not conclude that any unfair-seeming outcome is actionable. The bar is high and the inquiry is narrow. Many claims framed as covenant violations fail because the complaining party is really attacking the deal it agreed to rather than a genuine abuse of discretion.
A second misunderstanding is thinking the covenant can be drafted away with strong enough language. As the base entry states plainly, it cannot be eliminated by the Operating Agreement, and bad-faith conduct cannot be contracted around. You can narrow the gaps it fills by writing precise terms, but you cannot remove the floor itself. A third misunderstanding is assuming the covenant works the same in every state. It does not. The contours described here reflect Delaware law, which is why founders choose Delaware deliberately. Contracts governed by other states' law, including some banking agreements, may apply a different version. When the stakes are real, confirm which law governs and consult a qualified attorney.
Drafting habits that reduce disputes
Because the covenant fills gaps, the practical defense is disciplined drafting. When you grant discretion, state the standard that governs it, whether that is sole discretion, reasonable discretion, or a defined objective trigger. When a clause could produce a one-sided outcome, address that outcome openly so the parties allocate the risk on purpose rather than leaving it for a court to infer. Define distribution mechanics, capital calls, manager compensation, and exit rights with enough specificity that the major foreseeable conflicts have a written answer. Every gap you close is one fewer place the implied covenant has to operate.
It also helps to document the purpose behind unusual provisions, sometimes in recitals, so that later disputes about reasonable expectations have a contemporaneous record. For a non-resident founder using a $297 one-time formation service to stand up the entity, the temptation is to accept a generic Operating Agreement template and move on. That is reasonable for a true single-member company with no outside stakeholders. The moment another member, an investor, or a meaningful commercial partner enters, the template's silences become the covenant's playground. Investing in a tailored agreement at that transition, reviewed by a Delaware attorney, is the most reliable way to keep good-faith disputes from arising in the first place.
Putting the covenant in context with your other obligations
It is useful to map where the implied covenant fits among the other duties a non-resident founder juggles, because each obligation has a different source and a different enforcer. The covenant is contractual and enforced by the other party to the contract through the courts. Your franchise tax and Form 5472 obligations are statutory and enforced by Delaware and the IRS, with the $300 annual franchise tax due June 1 and the $25,000 penalty attached to a missed 5472. Your EIN, obtained for free by filing Form SS-4 and typically issued in roughly 8 to 10 business days for non-residents without a Social Security number, is an administrative identifier, not a contract. Keeping these categories separate prevents the false hope that good faith in one area excuses a lapse in another.
Beneficial ownership reporting is another category worth noting because the rules changed. Under the FinCEN Interim Final Rule of March 26 2025, entities formed in the United States, including a Delaware LLC, are exempt from the Corporate Transparency Act beneficial ownership information filing. That exemption is a regulatory matter and has nothing to do with the implied covenant. The pattern across all of these is consistent: the covenant governs private bargains, while your tax, franchise, identifier, and reporting duties run to government bodies on their own terms. A founder who understands which obligations are contractual and which are statutory will manage both more calmly and will know when good faith is even part of the conversation.