Is it permissible to put challas on the blech on shabbat morning on top of another pot that’s turned upside down and then putting a small towel on top of it but making sure the challah is not covered on all sides?
Yes, this is permitted.
But putting something between the challah and the blech there is no longer a problem of “mechzi kemevashel” (resembling cooking) and if part of the challah is uncovered there won’t be a problem of hatmanah.
Although some are stringent and only permit placing foods on a full pot (and not an upside down empty pot), one can be lenient in this matter.
Concerning heating up bread, see Iggros Moshe Orach Chaim 4:74:34; Otzros Shabbos p. 101, citing from Shevet Ha-Levi; Orchos Shabbos 1:p. 100. See also Yevakesh Torah, Shabbos, p. 172, who writes at length concerning whether one must be concerned for the hardening of the challah (and its becoming toast-like), and concludes that one may be lenient in this matter.
Concerning the matter of placing food on an upside down pot, see Shemiras Shabbos Kehilchasah note 112; Shevet Halevi 1:91; and see also here, note 12-13.