I don't think this should be allowed. Or that Nintendo should be able to do this.
This is like buying a digital sketchbook, in which you can draw and share anything. Your work or creation is not monetized, you aren't selling it. But Nintendo ends up having a problem because you decided to share the artwork of one of their character that you made.
The key thing is the word Mario. If they want to make a mario style game on dreams then they shouldn't have used assets that relates to Mario in any shape or form. Why not just make new characters?
That's like if ubisoft made a Mario Rabbids game without Nintendo permission.
Pocky Lover Boy!