The issue with the Out of Memory Error and BAIL errors after installing MIIS SP2 or installing ILM 2007 can be resolved with a Hot fix:

ILM 2007: KB 938014
MIIS 2003 SP2: KB 936306
IIFP SP2: KB 938015

I had to request these from Premier Support as they were not available on the KB.

This brought the version up to:  3.2.1001.0 (Service Pack 2)

This has resolved my current issues after applying SP2.

UPDATE:

Brad Turner picked up more details from PSS on this error which you can read about here