He wants to be a WP hosting website, basically blogs for other people. By offering this service he would like to put his adsense on thier pages in return for the hosting being free i assume.
Ah, much clearer. As long as you put it in your terms and conditions that all blogs are subject to advertising then you'll be OK. You may with to go over other blog hosting websites TOS's and AUP's to give you and idea of the sort of things they mention.
Yes, perfectly legal. For a reference, that's how Wordpress.com operates. Check out mu.wordpress.org as this is the software that site is based on.
It is completely legal because that is how the business model of livejournal itself works - host pages for other people in return for the right for showing ads on their pages.