I usually don't jump in on "drama threads" but will throw in my
on this topic.
If SEM/SEO promotion isn't stated on the TOS then he is owed money.
This is the reason that in mainstream the TOS is shown up front immediately and addresses this same exact issue you guys are having here. MOST have a list of terms that are off limit or a disclaimer regarding SEM bids and promotion. The fact it was stated that he is making money off type-ins or off the trademark/company name is a pretty moot point, it should not really matter especially if nothing was stated in the TOS.
Same thing goes with domain extensions, it won't rank unless there was some work put into it and if it ranks higher then the actual site it's because of work put into it. How many sites have you seen with XXXblog.com or XXXXwhatever.com? Some affiliates will promote this way because they want full control over the the landing for analytics and tracking.
When I was doing independent SEO ONLY traffic campaigns... I was banned by over 5 programs until I explained and showed them the method and strategy, after they were all very understanding, appreciated it and even offered to help to increase traffic sources.
End goal is sales, penalizing someone who is working for you is pretty defeating. Legally none of it was stated on the TOS, but from a general business relationship standpoint - it's not good. Pay, update TOS end of story man...it's better that way.