I love to serve as a reference for most former employees. But I've also occasionally been asked to be a reference for employees who I can't honestly recommend.
Here are some ways to handle reference requests when you can't recommend the candidate:
1. Whenever possible, warn the employee in advance that you won't be able to provide a positive reference. You may still receive calls from reference-checkers who go outside of the list of references provided by the candidate, but this should minimize it.
2. There's an easy out if the employee worked for you more than a couple of years ago: You can explain to the reference-checker (or the employee herself) that you don't feel equipped to be a reference since her work for you was so long ago and you can't remember the types of nuances that reference-checkers are looking for.
3. If the employment was more recent and #2 isn't feasible, you can fall back on saying you can only confirm title and dates of employment. (Although be prepared for a savvy reference-checker to ask if this is your policy across the board or just for this candidate, or to offer you a release from the candidate.)
4. Last, consider honesty. Frankly, as someone who has to check references myself, I'm grateful when I encounter the rare reference willing to be candid about weaknesses. After all, reference checking (and the whole hiring process, for that matter) is all about finding out if the candidate and the job are a good match. If they're not a good match and it's not uncovered until it's too late, the company will be stuck with a poor performer and the employee will be stuck struggling in a job and maybe even losing it down the road.
However, if you do choose to provide a reference for a poor performer, stick to objective facts you can prove. (Despite corporate paranoia about defamation cases, employers are permitted to provide negative references as long as they're truthful -- but you must be able to prove what you said was indeed true.)