Not hitting the right people
The problem is that the justification for the ban is a breach of the TOU for XBox live but there's a disconnect between the person agreeing not to violate the TOU and punishment applied. Lets say that the xbox is owned by someone who hasn't agreed to the TOU but modded the console. Then an Xbox live enabled profile uses the console and the owner of the console now has abox that's been crippled due to TOU violations that he's not signed up to.
My eight year old has just lost a level 103 Viva Pinata profile (hey - it's important to him OK?)because his elder brother took the memory card round to his mates house for quick blast of illegal MW2. The 16yo is fine because his profile's been recovered, but the 8yo is screwed because I didn't let him sign up to Live.
Fact is you can't be punished for breaking a contract you haven't signed up to and that's what MS are doing. Now you can argue that there are terms that allow the removal of the signing functionality but MS didn't use those - they used the TOU of the XBox Live contract which is distnctly differnt to the console licensing
What they should have done is banned the profile thus linking the violation to teh person breaking the rules.- but that would have cost them a lot of money. On that basis this lawsuit has every chance of succeeding since persons who haven't violated the TOU have been damaged directly by MS actions.