The sollution was to not let the phone boot up in Android before RSD lite signals "PASS"
So after it goes to bootloader and flashes the sbf, you should hold down the "up" key (or right if you look at the phone vertically) on the d-pad to make it go into bootloader again instead of normal Android. RSD will still signal "PASS" then close RSD, turn off phone and boot into recovery to apply update.zip. Working now, my 'stone is rooted.
So after it goes to bootloader and flashes the sbf, you should hold down the "up" key (or right if you look at the phone vertically) on the d-pad to make it go into bootloader again instead of normal Android. RSD will still signal "PASS" then close RSD, turn off phone and boot into recovery to apply update.zip. Working now, my 'stone is rooted.