Hi Joe -- So I just upgraded to 10.8, and I was able to get one of the polys to happen, and I'm guessing the other one has topology issues. I tried to find Data Reviewer (On the main menu, click Customize > Toolbars > Data Reviewer.) but it doesn't appear in my toolbar search. I'm not super clear on how to run topology after the feature has been created... seems you have to set up the rules beforehand?
Anyway, here is a snapshot of the polylines, with the inner polygon having been successfully created. I really only need the donut poly, but couldn't get that to happen so thought I'd try to make two and then cut the bigger one with the smaller one.
Here's the error message: (I'm not sure what the part about overlapping the polygons means... ?)