If a short delivery of shares occurs, and the exchange is unable to find fresh sellers in the auction market, then they are considered to be closed out. Instead of delivering the shares to the buyers, the exchange makes the settlement in cash, which depends on the close out rate.
The close out rate will be at its highest in the exchange from the trading day till the auction day for the scrip which was short delivered, or 20% above the official closing price on the auction day, whichever happens to be greater. This will then get passed to the buyer. You can consider it somewhat as a compensation to the buyer for the non-delivery of the shares.
Let’s understand this with an example.
Think that you have bought 100 shares of TATA Motors for Rs. 500 each and these shares were short delivered, which is why you don’t receive the delivery on T+1 day. The exchange will then organize an auction from where it will attempt to find fresh sellers who can deliver 100 shares of TATA Motors, so that they can be finally be delivered to you. If no fresh sellers happen to be in the auction market, then the trade gets settled by closing out.
Now assume, the official closing price of TATA Motors on the auction date, i.e., T+1 was Rs. 600. In this scenario, the exchange will close the trade at Rs. 720 (20% higher than Rs. 600), and the seller of the stock who defaulted will have to incur an auction penalty of Rs. 12,000 (720 – 600 x 100). So the buyer would get Rs. 72,000 in total, i.e., Rs. 60,000 which is the closing price on the auction date along with Rs. 12,000 which is the auction penalty.
However, if the price of TATA Motors had reached Rs. 760, i.e., from the trading day till the auction day, then the close out would have been done at Rs. 760 and not Rs. 720 as it is higher than the closing price + 20% of the auction penalty of the TATA Motors.