Yes they do. Its their game, its their character creator. Every polygon on those characters, was handmade by a person working in Illusion. Its their creation by definition.
That is also why I doubt some random guys sued him and that they actually had any rights on those characters. I mean you can sue anyone for everything but it would've never worked out. The second he would mention all those characters were made in the koitatsu character creator, the case would be dropped immediately.
Maybe Arc just got cold feet? Or he didn't want to go to court over Hentai? Who knows?