I've had a little time testing this problem(up until recently, I could not reproduce the busybox error on any of my customized LiveCD's). I think the problem is due to the version of squashfs used to build the LiveCD.
The ubuntu hardy repos do not have the latest version of squashfs-tools yet. Try uninstalling squashfs-tools and then downloading:
from the debian ftp. Then try to rebuild your custom hardy iso and you should not get the busybox error when testing in QEMU/Virtualbox.
To find out if this is your problem, take your borked busybox-ISO and fire up your iso in QEMU/Virtualbox and hit F6 at the boot menu, and then remove the quiet and splash lines. You should see text very similar to this:
If you see that, then it is obviously hanging while trying to read the squashfs. I think part of the problem is bugs in squashfs as well as the recently added lzma compression.
Registering unionfs 20060916-2203
unionfs: debugging is not enabled
loop: loaded (max 8 devices)
squashfs: version 3.2-r2 (2007/01/15) Phillip Lougher
BusyBox v1.1.3 (Debian 1:1.1.3-3ubuntu3) Built-in shell (ash)
Enter 'help' for a list of built-in commands.
/bin/sh: can't access tty; job control turned off
I hope this helps.