Strange that your host tells you to use FQDNs for your error redirects, that isn't very common (usually the redirects are relative to the root directory).
You don't need to enclose your path to htpasswd in quotes, what I mean is that you shouldn't need to, though it looks like your host has some interesting tweaks setup, so perhaps you do need to (but it isn't common).
You also do not technically need to enclose your password protection commands in the directory block. You should simply be able to remove <directory blah bla> and the closing directory and have it work, the only reason you might need it is if you want that htaccess to be your global htaccecss. But in order to avoid password protecting the entire site, you would use the DIRECTORY block to say only password protect this area, not the entire site. The easy workaround is to upload an htaccess with just your password prorection (no directory) into your members area.
Also, you are storing your htpasswd file in a publicly accessible area...this is bad. That password file can be gotten to and sniffed. You need to always (if possible) place your htpasswd in a non-web accessible directory (above your root or www or html or htdocs directory).
Are you sure you have the correct path to your htpasswd file? With some virtual hosts, the path to the file can be slightly different than what it appears.
Technically, nothing is wrong with your htaccess, if there was a problem with it, you'd more than likely get a 500 error. Not being able to find your htpasswd file at the location you specified can sometimes cause a 403 error, and sometimes cause a 500 error. It depends on the server.
It should be working, though there are a few curious items (as I mentioned)...it is odd, though. Try removing the directory enclosing, as I indicated, and remove the quotes from your htpasswd path. Also just double check you have the correct path to your htpasswd file.