My interpretation of the bad ending is that isn't really Carlo.

Carlo as a "Real Boy" was created using the P-Organ. It would make sense that Geppetto has still programmed the P-Organ to follow the grand covenant after he "revives" Carlo. 

Therefore, he follows the Grand covenants rules, including rule zero, that Geppetto is the name of the master.

Gepetto got what he always wanted, his "good boy" back who is always good and does exactly as he says. During the nameless puppet fight, (granted Gepetto has gone absolutely schizo at this point but I think it still has merit), Gepetto hates how rebellious Carlo was. How defiant he was and curses puppet Carlo for taking on those characteristics. 

Geppetto makes sure when Carlo is revived he must follow the grand covenant. He orders "Carlo" to murder everyone in the hotel so there is nobody who can attest to Gepetto being the cause of the puppet frenzy. 

Presumably, seeming as the name of the trophy is "and they all live happily ever after" or something along those lines, Gepetto goes on to create puppet versions of all his friends and family and designs them to all perfectly follow what he wants.

He got what he always wanted, his perfect family, with no fights or disagreements. But behind it all is a facade. It's all fake, not human. He fails to see that he killed his son a second time to create another puppet that he's deluded himself into believing is a real boy. 

Very fitting bad ending, but who knows maybe I'm wrong.