MySQL 5.5 Runs Out of Memory, Drops All Connections When Creating Many Databases
The first thing that comes to mind is the Server Model : db.m1.large
What limiting factors are placed on a MySQL RDS?
If you spin up an Amazon RDS instance of MySQL, you would subject yourself to whatever  constraints are given. All models of MySQL Amazon RDS have the same major options but differ in only two aspects

max_connections
innodb_buffer_pool_size

Here is a Chart I posted Last Month
MODEL      max_connections innodb_buffer_pool_size
---------  --------------- -----------------------
t1.micro   34                326107136 (  311M)
m1-small   125              1179648000 ( 1125M,  1.097G)
m1-large   623              5882511360 ( 5610M,  5.479G)
m1-xlarge  1263            11922309120 (11370M, 11.103G)
m2-xlarge  1441            13605273600 (12975M, 12.671G)
m2-2xlarge 2900            27367833600 (26100M, 25.488G)
m2-4xlarge 5816            54892953600 (52350M, 51.123G)

I posted this in my other posts in the DBA StackExchange

Local database vs Amazon RDS
Scaling Percona datacenters: setup and replication

You are using m1.large. Since the InnoDB Buffer Pool is 3/4 of the Instance. That's means you have 7.2G but only 1.8 is usable. That model is capable of having up to 623 connections. Each connection can consume memory because of

join buffers
sort buffers
read buffers
thread info

Amazon RDS is simply micromanaging resources. Since DB Connections can consume RAM, connections are probably being disallowed due to the lack of RAM needed.
SUGGESTIONS

Try reducing InnoDB log IO innodb_flush_log_at_trx_commit=0 during the mass creation
Make sure you are not doing large transactions during any automatic backups or snapshots
Try a bigger server model m1.xlarge or m2.xlarge