I had same issue with Yamaha gens I just purchased. The EMSHW-50C is doing its job and telling you there is no ground detected. I just connected a ground from the gen grd terminal to the chassis of the fiver so the EMS could see the gen ground.
As for the bypass, mine is down for normal operation and up for bypass. If you are seeing the fault codes of E-2 (if I remember correctly) you are in the normal position. I believe it will indicate such if you are in bypass.
I will let others chime in as to whether it is needed as a safety feature (maybe not). For me it is needed to allow the EMS to do its job.