Well that's the PokeMMO party line, and while I personally think it's somewhat reasonable, you have to understand that the legality is irrelevant. If Nintendo wanted to shut it down, they could. It doesn't matter if it's legal - court costs and time taken to actually deal with a lawsuit would cripple the game.
The legality of mods is questionable - companies have certainly succeeded in getting mods of games to be taken down in the past. Again, even if they would win the court battle, see above.
Calling it free advertising isn't quite right, and I doubt that it is what Nintendo has in mind anyway. My assumption is that Nintendo would much rather have advertising that actually, you know, made them money. From Nintendo's point of view, this game at best doesn't steal any of their customers, and at worst drives people to give PokeMMO money instead of buying their new games/devices/trash.