The Web.config setting is only used when the initial site is created. Since the Sqlite version ships with a db that already has the site created it does not apply. You can change the password format from Site Settings page but I recommend backup the db first as I have not tested that in SQLite at least in a long time.

Hope it helps,

Joe

Make sure you have this in Web.config or user.config:

<add key="AllowPasswordFormatChange" value="true" />

If its a multi site intallation, you may have to go to site settings in the root admin site, choose the child site from the dropdown and then change it. 

Hope it helps,

Joe