Some clarification here.
Shorting in the stock market is the act of selling a share of a company with the intent of follow up "buy" (usualy in a short period of time) at a lower price. The net effect within a brokerage house, that the broker will "borrow" a share from one customer, sell it, give the cash to the person who did the shorting and when the follow on buy order gets filled, the broker then replaces the "borrowed" share. The share owner receives the same value (1 share for 1 share) and perhaps some minor interest payment, the seller receives the proceeds of the sell but then has to buy back the stock at a HOPEFULLY lower price point. In essence, the person doing the short, pockets the price difference on a down swing (minus any brokerage commissions of course). This is perfectly legal.
A NAKED short is doing all of this WITHOUT A COVERING STOCK! This is esentually electronic counterfeiting stock certificates which SHOULD be illegal and get you jail time but the SEC has not enforced or to my knowledge, even had a single public trial of anyone for naked shorting.
One form of a naked short with a brokerage house is essentually conducting the sell but recording the "borrow" of the stock as a dollar transaction on their books. This creates a downward preasure on the stock that is not controled by supply and demand. Without the covering stock, the brokerage firm could in theory, sell as many shares as they wanted and keep piling up thier accounting books with ledger entries that they "owe" stocks (need to buy the shares back). But if their is no policing to drive the brokers to re-purchase those shares within a short time period, then there is a artificial devaluation of the stock. Something that hurts all the other investors and the company itself.
I see more to it than that. We can agree that corporate law is good, maybe even that derivative trades like shorts are good --but shorts create shares. Whenever money is loaned and the bond is used as collateral for another loan, then we say money is created (not counterfeited) --even though some people will object that the money was created out of 'thin air'. This same argument is used to justify a naked short sale, because when a borrowed stock is sold, it makes it so twice as many people now have those shares registered in their portfolios. The additional shares have been well, created.
I got no problem with the SEC saying it's illegal, but then they have to enforce their regs. I'd have no problem with the SEC voiding the reg either. IMHO what's important is consistency and transparency.