enigma1 - 3:06 pm on Dec 15, 2011 (gmt 0)
It is broken and Google warns that it might cause problems leaving it like that.
No, it just means you don't know how to customize an error page.
In options 2 or 3, GoDaddy's server will respond with a 200 HTTP error code - meaning that the page exists and was served properly.
Right, therefore it leaves you with option-1 at the moment. So either change the code of your site to support them or use the default error page of the host.
And providing the same 404 page for invalid requests doesn't help visitors.
I don't know how much they'll demote a site for soft 404s I believe is subject to problems with the site's internal link structure.