Although you cant short certain financial stocks. What happens if you are short via a put option, or covered warrant, and the company is nationalized/chapter 11, is your trade closed at the maximum premium for shortholders, or is trade just suspended (no market) and you could lose your whole premium, assuming no trading before expiry?
Most of the time, the stock continues to trade, even if it's on the pink sheets. Examples include LEHMQ and WAMUQ. FRE, FNM and AIG all continue to trade under the tickers they had pre-nationalisation. In the unlikely event that the stock no longer trades, you could try to exercise your long put. I'm not sure what would happen at settlement, when you would be required to deliver non-existent stock to the put seller.
If it still trades on the pinks - you will have to deliver the pink. However, most of the options are cash settled. Not sure if the guy who is short put and get excersized is going to demand to take the pinky. He may ask for cash settlement as well. If the stock ceases to trade - that is it. you made your full to 0 trade.
I don't quite understand your idea of "asking for cash settlement". To me that sounds like a negotiable contract. I believe that stock options are much more simple than that. A put buyer has the right but not the obligation to sell. The put seller, if assigned, must buy at the strike price. However, if the stock goes to zero, then how does an uncovered put buyer (ie, long put + no position in stock) deliver the stock to the put seller?
When you excersize an option contract, you can instruct your broker for a cash settlement. A lot of times this has to do with margin and buying power. Suppose you own 1,000 calls on GOOG at 400. At expiration its at 450. You're making 50 points. However, if you chose standard excersize, you will have to shell out 1,000 * 400 = $400,000 to get this position. Then you will sell it for 450,000 and make 50 k profit Now suppose you bought your 400 calls when Goog was at 100 and they were WAY OUT OF MONEY and cost you like $3.00 per call. you used 0 margin (cuz you cant) and you bought $3,000 of the stuff. ANd, you only have 30,000 in your account. How are you supposed to excersize your call when you need 400k to acquire that position? Answer: cash settlement. Broker simultaniouslyu excersizes and sells your position for a cash settlement.