Unfortunately, there is nothing illegal about what the competitor is doing. We have dealt with similar issues in the past with some of our clients and have found that the advertiser is not breaking Google's TOS. Technically speaking, the competing advertiser is completely within their rights, especially if the brand they are cloning is not officially trademarked.
This is not to say that it is ethical, however. As a marketer and advertiser I would personally have a hard time doing this myself or justifying my team in doing it. We often bid on competitor's names, but we never try to make it look like we are the competitor.
Is it clever? A little bit. Could it get you a positive ROI? Probably. Is it worth it? Nope. In many industries a strategy like this could destroy a company's reputation or ruin interindustry relationships. Personally, I believe the longterm consequences are not worth the temporary reward.