Wouldn't this be a common scenario given the very nature of the risk?
It's similar to what happens when you can't pay your mortgage. If you are shorting you'll have to put up some margin( cash or cash equivalents representing some percentage of the dollar amount you shorted.)
if the short starts to move against you, you'll get a margin call and be required to put up more collateral.
Eventually if you can't pay you go bankrupt and your counterparty get's what they can in bankruptcy court.
Not surprisingly this is called counterparty risk and has become a big area of focus for risk managers recently.
The "person" you borrowed the stock from may well lose out, but we're talking about huge institutional investors that lend stock thousands or millions of times a year, or even day, and the fees more than make up for the few losses they incur.
This is not fundamentally different than any other loan.