This is a legal answer. This is not legal advice. You shouldn't be trusting legal interpretations from an unqualified, Canadian secondary school student. I advise you to seek professional advice from a qualified person.
The clause is basically saying, that, if you create a derivative work, you must not change the work in such a way as to be harmful to the original author, be it honour, reputation or the like.
In my view, that's preserving the author's moral rights. There are some jurisdictions, where moral rights can be assigned, waived, revoked, etc. This seems to be a way to explicitly say that no moral rights are waived, in whatever way whatsoever.
But what's a moral right in law? Moral rights are the mechanism for an author or creator to have some integrity in their work.
So does the clause make it non free?
Even if the clause didn't exist, then the laws in some jurisdictions would themselves make the license non-free, because the law doesn't permit it. Moral rights are always there. Fun stuff.
Regardless, let's see the clause more carefully: (emphasis mine)
You must not distort, mutilate, modify or take other derogatory action in relation to the Work which would be prejudicial to the Original Author's honour or reputation.
However, "prejudicial" and "derogatory" can be incredibly difficult to define.
In Canada, there's a bit of a rather infamous case involving moral rights: Snow vs The Eaton Centre Ltd (Sorry, I can't seem to find any actual judgment from the case)
You may have heard of The Eaton Centre in Toronto, which is quite a large downtown shopping centre. Within it, is an artistic work - birds that hang down from the ceiling. It's known as the "Flight Stop" sculpture.
The case involved the Eaton Centre adding ribbons to the birds necks, in celebration of Christmas. Snow however, challenged this, saying that this was infringing on his moral rights, even though the Eaton Centre had full commissioned Snow to create the work.
The Ontario Court judge agreed, and stated that this was an infringement, saying that the added ribbons did distort the work. This legal article states:
Snow clearly believed that his honour or reputation had been affected by the defendants' acts. This view, being “shared by a number of other well-respected artists and people knowledgeable in his field”, was “reasonable under the circumstances”. Accordingly, O’Brien J. was prepared to give considerable weight to the artist’s views on this question, so long as they were “reasonably arrived at”. In other words, a breach of s 12 (7) could be satisfied by the artist’s own perception, supported by some credible testimony from members of the public or the art community.
Another Canadian case supports this (and again, I can't find any judgment -_-), which supported the former view. It held the following when determining infringement (if Wikipedia can be considered reliable for this):
the Court noted that prejudice must first be determined on a subjective standard based on the author's opinion. Second, it must also be determined on an objective standard that is based on public or expert opinion in order to establish that the author's opinion was reasonable.
I doubt this is the case in many other jurisdictions around the world however, particularly the United States. I'm not familiar with any law in other places, so I won't comment on those jurisdictions.
Now I'm talking too much :P
Basically, the clause doesn't make the license non-free, as it is simply an explicit statement saying that no moral rights are waived, assigned, or transferred. Even if such a clause didn't exist, it would still exist in copyright law, in various jurisdictions around the world.