I had the same problem with them refusing to cover the rust on the inside seam of my 1999 328is a few years back. They said the fender had been repainted and therefore would cover the hood rust, which was on the opposite side and have never been repainted. After several go arounds with the local dealer, their bodyshop and BMW NA, I finally wrote a letter to the owner of the dealership letting him know what was going on and that I would share my experience on all the BMW boards, and who ever else would listen - they ended up repairing it for free.

The only problem with yours is you tried sanding it down - now they have no way of telling if it was a scratch, or if you had rust.