Why can't stocks with prices below $1 keep reverse splitting to avoid delisting?

Let's start with defining what a reverse stock split is? A reverse-split is a corporate action in which a company reduces the total number of its outstanding shares. A reverse stock split involves the company dividing its current shares by a number such as 5 or 10. A reverse stock split is the opposite of a conventional stock split, which increases the number of shares outstanding.

Companies have to meet minimum requirements to stay listed on exchanges. The minimum requirements vary by exchange. Let's discuss the minimum requirements for the Nasdaq Capital Markets Companies before answering the question. Each company listed on the Nasdaq has to meet the minimum requirements of at least one of the columns.

A direct limitation on the ability to do repeated reverse stock splits is the requirement to have at least 500,000 publicly held shares. Note that the 500,000 publicly held shares is not the same thing as shares outstanding.  Publicly held shares equals total shares outstanding less insider holdings. Insider holdings include shares held by the company's officers, directors, employee stock ownership plan and shareholders with 10% or greater beneficial ownership of the company's shares. Often, companies with smaller market caps have concentrated ownership by insiders or significant shareholders, which more severely constrains the ability to do reverse-splits.

Why do exchanges set these minimum requirements? One possibility is to improve profitability of the exchange. While small stocks pay exchange fees, the exchange also earns revenue by levying taxes on trades. The margins are very low, so a lot of transactions need to be occur to produce real value. This story makes sense if their is a fixed cost to having a stock trade on the exchange and the contribution to the fixed costs is not adequate. Profitability has been an issue for exchanges, which is one reason exchanges have been merging with or acquiring other exchanges. These combinations have synergies by cutting duplicate IT costs for example.

Another possible reason for the minimum requirements is to keep investors out of stocks that are going to perform very poorly. The exchanges have some incentive to weed out poor performers so that investors look at companies trading on the exchange as more reputable. Reputation may lead to lower costs of capital for the firm because of greater trust by investors.

Let's see if reverse stock splits are associated with poorer subsequent performance. In theory nothing about the fundamental value of the business has changed given a stock split or a reverse stock split. However, a variety of papers have documented abnormal returns post splits. Hemang Desai and Prem C. Jain (1997) finds that 1-3 year performance of common stock following stock splits is 7.05% and 11.87% respectively. The 1-3 year performance following reverse splits has abnormal returns of -11% to -34% respectively. 

The longer term abnormal returns are a puzzle and suggest that investors under react to information about the business revealed in the corporate action to reverse split the stock. Thus removing under performing companies protects investors. 

However, why doesn't the information enter the stock price immediately? Why haven't investors learned about this pattern from historical data and erased the pattern with diversified portfolios shorting reverse split companies and going long forward split companies?

A few theories have materialized to try and explain the information content in a stock split. The first theory relates to managers’ private information about firm fundamentals which the market infers from a stock split announcement, while the second theory relates to increased liquidity that stocks achieve via a split. A more recent catering theory argues that managers split their stock to cater to investors who value lower priced stocks relatively more during certain times. However, none of these theories explain why the pattern in returns has not been exploited immediately.