If we dispense with the metaphors, when a company goes bankrupt generally the value of everything goes to 0. Options values are zeroed out - so if you're short puts you'd lose and if you're short calls you'd win. Visa versa if you have a long position.

Similarly, if you're long shares then the value of the shares you have drops to zero. If you're short shares, then there is no longer anything to cover and you keep the money you received for selling your shorts minus any premium you might have paid to borrow the shares.

Theoretically you still have to "buy" the shares back to return them to who you borrowed from. but since the value of all the shares is now 0 most brokers are just going to write this off.

Lots of people have a fundamental misunderstanding of what shorting a stock is, and think that there's some theoretical limit to how much stock you can short. There isn't; If I short a stock by selling it to you, you can then lend those maybe-existent shares to someone else. This is how you can short over 100% of existing shares.

The whole market is mathematically built on the assumption that you can sell a promise to something you don't have. All the tinfoil hat folks thinking there's some huge conspiracy are barking up the wrong tree and are making the wrong argument. Everything being done is both legal and mathematically sound. The argument that everyone should be making is whether or not this is an ethical practice, and whether firms should be allowed to leverage to this extent (especially when it involves consumer money, where the customers may not be fully aware of the amount of leverage a firm is using). Tighter regulation is needed to reign in practices like this or at least make what's going on clearer, but I personally find that unlikely in the current political environment.